With meme stocks once more riding a wave of retail trader enthusiasm, regulators are scrutinizing payment for order flow—the controversial payments that brokerages like Robinhood receive for routing trades to third-party trading firms, instead of stock exchanges.
Order-flow payments subsidize the commission-free trading that’s become the norm with U.S. retail brokers, but they are banned in markets like Canada and the U.K. Why? The concern is that the payments discourage brokers from obtaining the best trades for their customers—violating the broker’s duty to get a customer the “best execution” on a buy or sell order.
These worries cropped up in a speech Wednesday by the new chairman of the U.S. Securities and Exchange Commission, Gary Gensler. “Payment for order flow raises a number of important questions,” he told a financial markets conference. “Do broker-dealers have inherent conflicts of interest? If so, are customers getting the best execution in the context of that conflict?”
Gensler said he has asked SEC staff to examine order-flow payments (and other market structure controversies), then propose any needed rule changes.
To understand what the fuss is about, it helps to know what happens behind the scenes in a securities trade. When you place a trading order with a retail broker like Robinhood or Charles Schwab (ticker: SCHW)—say, to buy 100 shares of AMC Entertainment Holdings (AMC)—the broker passes that order along to a trading venue, where it can be matched with orders of other traders seeking to sell the stock.
Once upon a time, the trade for an NYSE-listed stock like AMC would take place on the New York Stock Exchange. In recent years, however, computerized market makers like Citadel Securities or Virtu Financial (VIRT) have taken an increasing share of trading volume from exchanges like the NYSE (now part of Intercontinental Exchange (ICE)), or Nasdaq (NADQ). As of January 2021, Gensler told his audience, the exchanges handled about 53% of trades, while 38% were executed at market makers like Citadel Securities.
There are a number of factors that brokers are supposed to consider when deciding where to route their customers’ orders for the best execution. Among those is the speed of execution, the likelihood of matching the entire order, and—perhaps most important—the price per share obtained on the trade.
Market makers profit by paying less to buy a share than what they can sell it for moments later. But they can compete for trading volume by giving up some of the spread to a broker and its customers. On Thursday, for instance, the market’s best bid for 1,000 shares of AMC stock was $42.87 a share, while the asking price for a similar amount was $43.78; leaving the spread on this volatile stock at 91 cents. Virtu filings say that it saved retail traders some $3 billion in 2020 in “price improvements”, by offering prices slightly better than the quoted spread.
A more controversial way to get order flow is to directly pay for it. The big market makers pay hundreds of millions of dollars a year to retail brokers for their order flows. Virtu filings show that it spent $660 million in 2020 on order flow payments (including some other market fees), as it brought in some $2.5 billion in market-making income. Monetizing order flows has always been a part of most retail brokers’ business models. It’s been practically the entire business model for the soon-to-be public Robinhood. In the first quarter of 2021, Robinhood’s filings show that it got $331 million in order-flow payments, up from $91 million in the prior-year period.
Retail brokers have always insisted that these order flow payments don’t deter them from routing trades to the markets where they’ll be best executed. They argue that the payments have helped subsidize the steady decline of trading commissions in the last two decades , with Robinhood finally pulling the industry’s commissions down to zero.
But regulators haven’t always concurred that order flow payments benefit customers. In December, the SEC filed administrative charges alleging that Robinhood had sent its customers’ orders to market makers that executed trades at inferior prices, in exchange for unusually high order-flow payments from the market makers. Even after accounting for Robinhood’s free commissions, its customers were left $34.1 million worse off, said the SEC. Without admitting the SEC charges, Robinhood paid $65 million to settle the case and promised to improve its disclosure and execution. The broker had previously settled a regulatory action alleging poor trade execution (without admitting the charges).
Market makers aren’t the only ones who pay to attract orders. Exchanges offer rebates of varying sizes for certain orders. An SEC pilot program to limit rebates was blocked last year when the exchanges went to court.
“Both types of payment for order flow raise questions about whether investors are getting best execution,” Gensler said in his Wednesday speech.
In 2015, a pioneering piece of data journalism in Barron’s presented the first-ever comparison of trade execution between the leading retail brokers and market makers. The market makers told us that they’d cheerfully give a broker’s customers better prices on trades in exchange for paying less to the broker for order flow. It was up to the broker to choose the trade-off between being able to get better prices per trade, or order flow payments (which the broker could, in theory, use to subsidize lower commissions or other service improvements). On average, the market makers had given up an increasing portion of the spread to retail traders.
The quoted prices that establish a stock’s spread are set in the trading that takes place on stock exchanges, however, and Gensler remarked Wednesday that perhaps these quotes have become less meaningful benchmarks as the exchanges’ portion of trading volume declines.
You can bet that in the coming months, brokers, market makers, and exchanges will be busy trying to persuade the SEC that order-flow payments can be good for retail traders.
Write to Bill Alpert at william.alpert@barrons.com
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