The Role of Reputation in Financial Markets : The Impact of Broker Dark Pool Scandals on Institutional Order Routing

Before changes to Regulation ATS in 2018, brokers were not required to disclose information regarding the operations of their private trading venues known as dark pools. As a result, most institutional investors relied on broker representations when deciding whether or not to send orders to individual dark pools. Over the past decade, several brokers have been fined for making misrepresentations to institutional investors as to how their dark pools operated. Using a hand-collected dataset of annual commission league tables for public pension funds and mutual funds between 2010 and 2020, we examine how these funds respond to breaches of trust by their brokers. We find that when a breach of trust becomes public, both public pension funds and mutual funds are more likely to reduce the commissions routed to the affected broker. While both pension funds and mutual funds appear to respond to the most egregious broker scandals, pension funds also react strongly when the affected broker offers only execution services or when the scandal is not the first for the affected broker. We find little evidence that sophisticated institutional investors respond differently to broker scandals, suggesting that either these investors are unable to internally detect broker malfeasance or they do not fully adjust their order routing prior to the public announcement of a scandal. Together, our results point to important reputation effects in the relationship between institutional investors and brokers, and suggest that institutions punish brokers that violate their trust