Financial Technology

Why Payment for Order Flow Made Trades Free But Left SEC Skeptical

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

1. What is payment for order flow? 

It’s money paid to brokerages for the right to execute orders coming from the brokerage’s retail investors. The firms making the payments are electronic wholesalers, also known as market makers, and include such giants as Citadel Securities, Virtu Financial and Susquehanna International Group. Between them, Citadel and Virtu handle more than half of the wholesale trading market; Citadel alone handles one in every four US equities trades. The payment recipients are retail brokers that range from newcomers like Robinhood Markets Inc. to veterans like E*Trade and Charles Schwab Corp. The payments are allowed if the market makers and brokerages are providing 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 lets them execute trades involving billions of shares per day. The top six such firms executed roughly $58 billion worth of share orders in March 2022, according to Bloomberg data. These firms make money by paying a little less to buy a stock, or by getting a little more when they sell a stock from retail orders. This small “spread” is essentially part of the price retail investors pay. These tiny profits on smaller orders add up, making it worth paying retail brokerages to have trades sent their way. 

3. Why the focus on retail trades?

Institutional orders are larger, can shift the price of a stock dramatically — exposing the market makers to greater risks if the price swings against them — and take longer to execute. Retail trades are smaller, so they have less of an impact on price, and can happen in a matter of milliseconds. 

4. How big is payment for order flow?

Total payments for order flow in the first quarter of 2022 came to $840 million for both equities and options trades, and $3.8 billion for all of 2021. The number of trades steered to retail wholesalers for equities this way could represent as much as 14% of stock activity, but has varied over recent months depending on the market’s conditions. 

5. How has this changed stock trading?

Payment for order flow helped to usher in the no-fee trading era. It gave Robinhood, the upstart financial-technology company, a reliable source of revenue that let it knock its price to trade down to zero, compared with a previous average price of $4.99 per trade. That pushed most of its competitors to follow suit in 2019. Retail trading took off during the pandemic disruptions of early 2020, with people making more investments while stuck at home. That enthusiasm has worn off. Average daily volume of the six larger wholesalers is down 47% from the January 2021 peak. Still, the momentum contributed to the migration of trades happening away from public exchanges.

6. Where did trading move? 

There’s been a steady increase in what’s known as off-exchange trading, which has grown from 11% of trading volume in 2004 to 40% in May 2022. Off-exchange trading, which includes alternative trading systems or dark pools, doesn’t display the investor’s asking or offer price, which is information that can drive stock prices up or down, potentially reducing profits. Only the results of trades are made public.

7. What’s the advantage for market makers of off-exchange trading?

Typically a wholesale market maker like Citadel Securities and Virtu will route retail orders through these venues or will “internalize” them by matching buy and sell orders from the flow of trades they’re handling. They say that their freedom from some of the rules governing exchanges means they’re often able to get clients a better price. Firms handling institutional orders may want to trade off-exchange to avoid disclosing the kind of larger orders that can shift prices. 

8. What do supporters of PFOF say?

The wholesale-trading firms say that along with 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 compared to the best displayed price on an exchange at the time, is on a pace to reach $3.7 billion for this year. Ending or limiting PFOF could have unintended consequences that lower these savings and end up hurting retail investors, they warn.

9. How about its critics?

SEC Chairman Gary Gensler has been one of the current system’s biggest detractors, but not its only one. Critics say there’s not enough competition among the giant players that dominate the execution of stock trades, and average traders don’t know if they’re actually getting the best prices for their transactions. Gensler has said trades aren’t “free” even when brokers don’t charge a commission, asserting that the costs are baked in somewhere in the system. His goal is to bring more pricing competition and transparency to the equities market through what could be a major overhaul.

10. What is the SEC doing? 

It appears to be focused on other ways to make the market more transparent following pushback from industry. The SEC is considering a move to lower access fees that exchanges charge brokerages to execute trades for some stocks, which could push more trading onto the exchanges. The agency also may propose changes that could affect the complicated system of rebates that exchange operators use to lure trading volume, they said. Additionally, the regulator is weighing a plan to force brokers to disclose more about how much trading with them costs compared with benchmarks, a metric known as price improvement, said the people. 

• A Bloomberg News article on how the SEC is pulling back from any move to ban payment for order flow.

• A Bloomberg Intelligence analysis of how the revenue from the bid-offer spread is carved up among market makers, brokerages and investors.

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

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

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

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