Unsatisfied ConvergEx customer. Photographer: Sanjit Das/Bloomberg.
Unsatisfied ConvergEx customer. Photographer: Sanjit Das/Bloomberg.

The Securities and Exchange Commission settled fraud accusations on Wednesday against ConvergEx, a group of brokers that, in the SEC's words, "held themselves out to the public as a unified conflict-free agency broker that charged explicit commissions for equity order execution." Surprise! Most of those words were false!

The basic deal was that you hired ConvergEx to do some pretty boring but big equity trades,1 and ConvergEx would do your trades for you on a purely agency basis and charge you a fixed stated commission. So you'd be like, "buy a million shares of Facebook," and ConvergEx would go buy a million shares of Facebook for your account and say, "okay we filled you at $55.05" or whatever and then charge you a penny a share for their trouble.

But in fact what would happen is that ConvergEx would secretly use a Bermuda affiliate broker-dealer (ConvergEx Global Markets Limited, or CGM), which would buy the shares at, say, $55.02, and then sell them on to the client-facing ConvergEx entity at $55.05, and ConvergEx would go to the client and say "okay we filled you at $55.05, so pay us $55.06 with the commission, thanks." ConvergEx called the extra three cents "trading profits," which is a little euphemistic,2 or "TP," which is not. "It was not uncommon for the amount of TP to be several times the amount of commission that the customer had paid," says the SEC.

How shady was this? A certain amount. One answer would be $107 million worth of shady; that's how much ConvergEx is paying in the settlement. And the settlement is full of boiler-roomy quotes, with the most representative being "You must take TP, take as much as you can get away with."

That's sort of a good rule for life? I mean, not calling it TP, but otherwise. This case feels uncomfortably like a metaphor for the financial services business. There are a whole lot of financial services that don't have an obvious intrinsic value, or even really a market price. You charge what you can convince people to pay you. The people who are easy to convince, generally because they're not paying attention, tend to pay more.

ConvergEx's business model was to find out how much it could get away with by figuring out who was paying attention. For starters, it actually disclosed up front to customers that it might do this:

Client authorizes ConvergEx, in its sole discretion and without notice, to use the services of one or more other persons or entities (including its affiliates) in connection with the execution, clearance and/or settlement of any Order and/or Transaction, or otherwise to service Client or perform its obligations, and that such persons or entities may act as principal and earn a spread[.]

So there you have it. The clients explicitly, by signing the contract, authorized what ConvergEx did.3

But that doesn't end the story, because everything else that ConvergEx did was built around hiding this practice -- which clients had sort of agreed to! -- from clients. Because ConvergEx "believed that customers generally did not understand Respondents' business model with respect to TP and would fire them if they learned the truth." Which is surely true; regardless of what boilerplate they signed, clients looking for a fixed penny-a-share-or-whatever commission were not also looking to pay a lot more in hidden markups.

So ConvergEx hid the truth. Not by lying,4 but by being sneaky:

CGM often took TP when customers were asleep during market trading hours because of time zone differences. On the other hand, CGM did not take TP from customers who actively monitored executions throughout the day through the receipt of real-time trade information.
Likewise, CGM, with the knowledge and approval of its senior management, did not take TP on trades if customers, prior to trading, requested a "€œtime and sales"€ report that would detail the times of execution and prices received on the individual executions underlying a customer's order, and thus expose any TP taken by CGM.
The CGM Division also suspended the practice of taking TP at times when it knew customers were scrutinizing their executions, in order to impress those customers and secure future business. In at least one instance, CGM suspended the practice of taking TP when a customer requested time and sales reports to analyze execution prices and then resumed taking TP after they were told that the customer was no longer conducting the analysis.

The result was that customers who were perceived to be "sensitive" to their execution price got good prices. Clients who were not "sensitive" -- for instance by being asleep -- would get worse prices. At worst, "CGM took TP in an amount that resulted in customers buying at a price equal to the market high of the day and selling at a price equal to the market low of the day."

Most amazingly, you could just ask ConvergEx not to screw you, and they wouldn't screw you. You just had to know the magic word. The magic word is "fiduciary":

Some customers asked Respondents to handle their trades on a fiduciary basis. When customers requested fiduciary treatment, Respondents did not take TP on those customers' trades and typically charged those customers higher disclosed commission rates.

That paragraph is important.5 You had a choice, as a ConvergEx client. You could pick one of:

  1. Pay a low fixed commission and keep a constant watchful eye on your execution.
  2. Pay a low fixed commission, take it easy, and pay much bigger secret markups.
  3. Opt out of the game entirely by saying the word "fiduciary" three times while clicking your heels together, and pay a higher fixed commission.

Not that ConvergEx told you that you had this choice, but that's the way it shook out. Group 2 in effect subsidized group 1. Group 3 paid their own way.

This is all very sordid but, again, it comes from somewhere. You can see a bit of ConvergEx everywhere in financial services: Sophisticated clients who pay attention get good prices, clients who know to demand fiduciary treatment get fair prices, and clients who don't pay attention -- who don't know where they need to pay attention -- subsidize everyone else.

It is usually not quite as blunt as this. Say you want to do a complicated structured trade. If you have your own sophisticated modelling capacity or check your price with multiple dealers, you will end up trading at a price that the dealer considers downright unfair. To him.6 If you hire an independent adviser to be your fiduciary, you will end up trading a pretty good price too, but you'll have the overhead of paying for the adviser. If you just go to one dealer and say, "I know nothing, charge me what you think is fair," the dealer will probably not charge you more than he thinks is fair. Because he's getting hosed on the other sorts of trades and he needs to make it up somehow. The dumb clients are the somehow.

It sounds unpleasant when you put it like that, but it's not like price discrimination is unique to the financial industry.7 It's just a little bit more naked in finance: The discrimination is less about need or willingness to pay, and more about sophistication. You pay more if you're asleep; you pay less if you're awake. ConvergEx just took that theory a bit too literally.

1 For instance, you're an endowment changing investment managers or strategies, and you need to sell and buy a lot of stocks. ConvergEx will go find shares for you, for a fixed commission. Supposedly!

2 ConvergEx took no principal risk, didn't make markets, didn't hang on to shares, etc.: there's no actual trading profit here. It's just gouging profit.

3 The SEC picks some nits with that sentence but they are not that compelling:

These disclosures did not state the regularity with which GTM and the CGM Division of G-Trade routed orders to CGM and took TP. These disclosures also did not state that GTM and the CGM Division routed orders for securities listed on U.S. exchanges to their affiliate in Bermuda, which took a mark-up or mark-down, instead of CES, their "€œU.S. trading arm" and a member of U.S. exchanges. Furthermore, Respondents did not disclose the amount of TP that they took on trades or indicate to customers that, in many instances, they were paying several times more than the agreed-upon commission amount.

Meh!

4 OK, also by lying, but the sneakiness is more fun. The lies are sort of boring and drab. Basically sometimes clients would ask if they did this, and ConvergEx would be like "no, why ever would you think that?"

5 You can tell because it's actually a footnote.

6 Winner's curse and so forth. Plus if the modelling is transparent it can be hard to justify a "fair" risk cushion plus a "fair" profit margin. "Oh, sure, we need to make sure you can afford your private jets," the client will say, and the dealer will be like "I flew here coach come on."

7 Are you aware of the Amazon Mom fake baby price discrimination controversy? You are now. The point is, there's no a priori reason to think that customers will always be less sophisticated than dealers. Sometimes they are more sophisticated, or trickier anyway.