The University of Chicago Business Law Review

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Wholesalers in U.S. equity markets are once again a focus of the SEC and scholarly debate. In this Comment, building on the empirical work of Schwarz, et. al. (2022), I present a model of the broker-wholesaler relationship based on the duty of best execution under FINRA Rule 5310 and the antifraud provisions of the federal securities laws as well as public disclosures by brokers and wholesalers. I suggest that the arrangement between a broker and a wholesaler on any given day is determined by the technology of the wholesaler, the likelihood of adverse selection, and the overall strategy of the broker. As a broker negotiates arrangements with different wholesalers, it inevitably makes tradeoffs between average price improvement, likelihood of price improvement, likelihood of price disimprovement, speed, and other measures of execution quality. Unfortunately, under current SEC regulations, brokers are not required to articulate order-routing strategies in meaningful detail. Unlike in other parts of financial markets where there are strong incentives for self-induced disclosure, there is an inefficient disclosure gap in the market for order flow, because no broker knows whether the benefits of wholesaler-specific disclosure will accrue to them or their competitors. Ultimately, I conclude that the disclosure gap limits competition and prevents customers from effectively monitoring brokers, and I propose a regulatory solution. I also discuss the SEC’s recently proposed Order Competition Rule and amendments to Rule 605.

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