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E*Trade Financial (NASDAQ:ETFC), one of the largest retail brokerage firms in the U.S., reported in its quarterly SEC filing that the Financial Industry Regulatory Authority (FINRA) has initiated a review of its historical order routing practices. The investigation is likely to look for signs that suggest the company routed customer orders to an affiliate even though it could get a better deal for its clients from other sources. If a conflict of interest is found, the company could be subject to “monetary penalties and cease-and-desist orders”.  Further, the company could see claims from customers if it is shown that it failed to act in their best interests.
The examination follows an internal review of E*Trade’s order handling processes that was initiated in November 2012 when Kenneth Griffin, a former member of its board of directors, raised concerns about them. At the time, Griffin was the largest shareholder in the company, but has since sold his stake.
E*Trade’s shares dropped over 3% after the news broke on August 7th. The company’s stock currently trades at around $14.50 per share. We are in the process of updating our model for the company and will soon update our price estimate.
E*Trade’s Market Making Business Is At the Core Of This Investigation
Market makers are entities that buy and sell shares at any point in time during market hours. They enable smooth functioning of the markets by allowing investors to execute trades even when there is no other buyer/ seller (liquidity) in the market. To make this happen, they post both bid and ask quotes for the securities in which they make markets. Since this process involves some risk, there is a slight difference between the two quotes, called the bid-ask spread. This spread is in essence a charge that investors have to pay for executing their trades.
Ideally, when a broker receives a customer order it has a duty to find a market maker that offers the best bid-ask quotes in order to reduce client execution costs. In its current investigation, FINRA is looking into whether E*Trade breached this duty by favoring its in-house market making business. According to recent data from Bloomberg, E*Trade directed more than a quarter of the order flow to its in-house market maker in Q2 2013.  That proportion could have been even higher in the previous years, since the brokerage has been improving its order handling processes since the internal review finished last year. 
Sale Of Market Making Business Is Already Underway
E*Trade has already announced that it intends to sell its market-making business. The business brought in around $93 million in principal transaction revenue last year. During the Q2 conference call, management said that they decided to exit the business because it is not core to the company’s operations. “Tightening economics” as well as potential operational and regulatory risks were also cited as reasons for the exit. E*Trade aims to announce a deal within the next 3 to 6 months. However, this current development could potentially complicate a sale of the market making business, as a buyer would likely want to see what the full impact of the review would be.Notes:
- Q2 2013 10Q, E*Trade Financial, August 6, 2013 [↩]
- What’s E*Trade Doing With Its Customers’ Orders Anyway?, Bloomberg Businessweek, August 8, 2013 [↩]
- E*Trade Drops Most Since April After Finra Probe: New York Mover, Bloomberg, August 8, 2013 [↩]