Why Pay For Order Flow Made Transactions Free But Left The SEC Skeptical

The way stocks are bought and sold in the United States has changed dramatically over the past decade, and at the heart of those changes is something called payment for order flow, or PFOF. This has made much of commission-free stock trading, which in turn has brought to the markets the millions of new retail investors who fueled the so-called meme stock revolution of 2021. But the PFOF has also become a focus of attention for the United States Securities and Exchange Commission, which after months of deliberation decided not to ban the practice but to develop other changes that could make the practice less profitable .

1. What is Pay for Order Flow?

It is the money paid to brokerages for the right to execute orders from the particular investors of the brokerage. The companies making the payments are electronic wholesalers, also known as market makers, and include giants such as Citadel Securities, Virtu Financial and Susquehanna International Group. Between them, Citadel and Virtu manage more than half of the wholesale market; Citadel alone handles one in four US equity transactions. The payout recipients are retail brokers that range from newcomers like Robinhood Markets Inc. to veterans like E*Trade and Charles Schwab Corp. Payouts are allowed if market makers and brokerages provide brokerage clients with what regulators consider “best execution” on trades. , a standard based on a combination of price, speed and other factors.

2. Why are they willing to pay for order flow?

Market makers have spent billions of dollars on sophisticated technology that allows them to execute trades involving billions of shares per day. The top six such firms executed about $58 billion worth of stock orders in March 2022, according to Bloomberg data. These companies make money by paying a little less to buy a stock or getting a little more when they sell a stock from retail orders. This small “spread” is essentially part of the price paid by retail investors. These tiny profits on small orders add up, making it worth paying retail brokers to have trades sent to them.

3. Why focus on retail businesses?

Institutional orders are larger, can significantly change the price of a stock – exposing market makers to greater risk if the price swings against them – and take longer to execute. Retail trades are smaller, so they have less price impact and can happen in milliseconds.

4. What is the payout amount for order flow?

Total payments for order flow in the first quarter of 2022 were $840 million for equity and options trades, and $3.8 billion for all of 2021. The number of transactions directed to retail wholesalers for stocks in this manner could account for up to 14% of stock market activity, but has fluctuated in recent months depending on market conditions.

5. How has this changed stock trading?

Paying for order flow helped usher in the era of fee-free trading. This gave Robinhood, the upstart fintech company, a reliable revenue stream that allowed it to drop its trading price to zero, from a previous average price of $4.99 per trade. This caused most of its competitors to follow suit in 2019. Retail took off during the pandemic disruptions of early 2020 as people invested more while stuck at home. This enthusiasm has faded. Average daily volume for the six largest wholesalers is down 47% from the January 2021 peak. Still, the momentum has helped trades migrate away from public exchanges.

6. Where did the trading go?

There has been a steady increase in so-called off-exchange trading, from 11% of trading volume in 2004 to 40% in May 2022. Off-exchange trading, which includes alternative trading systems or dark pools, does not display the investor’s bid or bid price, which is information that can drive the stock price up or down, potentially reducing profits. Only the results of the exchanges are made public.

7. What is the benefit to market makers of off-exchange trading?

Typically, a wholesale market maker like Citadel Securities and Virtu will either route retail orders through these platforms or “internalize” them by matching buy and sell orders from the trade stream they process. They say their freedom from some of the rules governing exchanges means they are often able to secure a better price for their clients. Companies dealing with institutional orders may want to trade off-exchange to avoid disclosing the type of larger orders that can alter prices.

8. What are PFOF supporters saying?

Wholesale companies claim that in addition to subsidized trading, investors are getting some of the best prices ever due to the sophistication of the current system. Price improvement, the amount a retail investor saved relative to the best price posted on an exchange at the time, is expected to reach $3.7 billion this year. Ending or limiting the PFOF could have unintended consequences that would reduce these savings and ultimately hurt retail investors, they warn.

9. What about his detractors?

SEC Chairman Gary Gensler has been one of the biggest critics of the current system, but not the only one. Critics say there isn’t enough competition between giant players who dominate stock trade execution, and average traders don’t know if they are actually getting the best prices for their trades. Gensler said trades aren’t “free” even when brokers don’t charge a commission, saying the costs are built into the system somewhere. Its aim is to bring more price competition and transparency to the equity market through what could be a major overhaul.

10. What does the SEC do?

He seems to be focusing on other ways to make the market more transparent following the industry’s setback. The SEC is considering reducing the access fees that exchanges charge brokers to execute trades in certain stocks, which could push more trades onto exchanges. The agency could also propose changes that could affect the complicated system of rebates exchange operators use to attract trading volume, they said. Additionally, the regulator is considering a plan to force brokers to disclose more about the cost of trading with them relative to benchmarks, a measure known as price enhancement, the people said.

• A Bloomberg News article on how the SEC is backing away from any decision to prohibit payment order flow.

• A Bloomberg Intelligence analysis on the distribution of bid-ask spread income between market makers, brokerages and investors.

• A Bloomberg Businessweek preview of Wall Street’s plans for the PFOF battle.

• A detailed look at the SEC’s early proposals by Bloomberg Intelligence.

• A Bloomberg article on Gensler’s views on PFOF and market structure.

More stories like this are available at bloomberg.com

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