Monday, April 21, 2008

Getting Robbed by your Broker

I had an interesting mailing from Fidelity today regarding “Important legal information for Fidelity clients”. With a banner that bold, I figured it was time to read the small print.

One of the most precarious situations for the customer of a brokerage firm is when the company operates it own clearing firm where the broker routes the customers' orders to. In my mind, this is worst than the simple payment-for-order flow set-ups with third party firms. A set-up where your order is routed to an affiliated company is the worse case scenario for an investor - a recipe for abuse.

In the case of Fidelity, the FBS routes your orders to their clearing firm affiliate, National Financial Services (NFS). The statement goes on to state that NFS looks at a number of factors when executing the order. The next section informs the reader that the order routing policies are designed to result in transaction processing that is favorable to its “customers”. Remember that the “customer” here is FBS, not you - the retail investor.

The next paragraph clearly states that FBS and/or NFS receives remuneration, compensation, and other considerations for directing orders to certain market centers. This allows the firms to get financial credits, monetary payments, rebates, volume discounts, or reciprocal business. Obviously the entire set-up is focused on making Fidelity money rather than getting the investor the best price for their trades.

Due to recent regulatory action, they now have to disclose these facts to investors who have accounts at Fidelity, and state the company will provide details of the compensation received in connection of the routing of a particular order upon request during the previous six month period.

In the past, the cross-ownership of brokerage and clearing/routing firms was not allowed. Unfortunately regulation got lax, setting the table in the 1990s for a significant amount of abuse. The recent notices coming from brokerage firms (Fidelity is not the only one) are a small step in informing investors of this conflict. The next proper step for the SEC is to force the separation of brokerage and clearing/routing activity. The utilization of related affiliate firms when routing brokerage customers’ orders should be strictly disallowed in the financial industry – it is the 21st century form of highway robbery.

Keep in mind that, despite this notice, I am a happy Fidelity customer for my retirement accounts. These funds are rarely traded and kept primarily in mutual funds that are part of their NTF family. I find Fidelity’s customer service generally to be excellent.