SCHW Charles Schwab Corporation

By Dave Michaels 

WASHINGTON -- The Securities and Exchange Commission's acting chairwoman signaled support for a wholesale review of a practice that funnels many small investors' stock orders to be filled by high-speed trading firms.

The system, known as payment for order flow, is decades old but has generated greater scrutiny as more individual investors trade on brokerage apps operated by companies such as Robinhood Markets Inc. Online brokers like Robinhood make money by selling customers' orders to firms such as Citadel Securities and Susquehanna International Group LLP, which trade with them.

In a letter made public Tuesday, SEC Acting Chairwoman Allison Herren Lee said regulators should examine such arrangements to make sure practices are fully disclosed and "consistent with best execution obligations." That requirement considers whether customers get a better price than what is currently quoted in the market, the speed of execution and the probability their order will be filled.

Ms. Lee's letter, which was sent in response to questions from Sen. Elizabeth Warren (D., Mass.), didn't say how or when the SEC might start a review of payment for order flow. An agency spokeswoman didn't immediately return a message seeking comment.

Ms. Warren sent questions to the SEC in January after frenetic trading in shares of GameStop Corp. and other so-called meme stocks created such volatility that some brokers had to curb trading to meet margin calls from their clearinghouses.

In the past, the SEC has repeatedly blessed payment for order flow, saying brokerages monitor for conflicts of interest and that it often results in better prices for small investors.

Nonetheless, the practice has long generated controversy, and the rise of commission-free trading has put more focus on it. Firms like Robinhood and Charles Schwab Corp. don't charge trading commissions and instead make money from other sources such as payment for order flow.

Some critics say the practice breeds bad incentives, since brokerages may be tempted to send customer orders to the market center that pays them the biggest rebate. Supporters, including many brokers and trading firms, say the practice is misunderstood and helps investors enjoy seamless trading and good prices.

A surge in trading among small investors has contributed to a bigger slice of trading happening outside of regulated exchanges. A record 47.2% of U.S. equity trading volume in January was executed away from public stock exchanges, up from 39.9% a year earlier, according to data from Rosenblatt Securities, a brokerage firm.

Ms. Lee's letter also said the SEC should consider new regulations, such as greater disclosure of short selling and steps to ensure small investors understand how options work. The Wall Street Journal reported last month that the agency had started to consider whether to draft new rules relating to short-sale disclosures.

One provision of the 2010 Dodd-Frank financial overhaul law required the SEC to issue rules within two years that would enhance public information about the lending or borrowing of securities. Another told the agency to publicly report, at least once a month, on how much of a company's shares have been shorted.

Ms. Lee also wrote that regulators should consider requiring brokerage firms to disclose more about how options trading works and examine whether retail customers understand the products, which allow traders to speculate more cheaply on stocks without buying the shares. Robinhood Chief Executive Vlad Tenev said last month in testimony to the House Financial Services Committee that Robinhood has enhanced its educational materials about options trading and boosted the eligibility criteria for new customers seeking to trade certain kinds of options strategies.

The SEC is conducting a broad review of the trading in GameStop shares, including whether any of the trading was manipulative and whether brokerages followed all applicable rules.

"We are continuing to analyze the recent market events, and the outcome of that review may ultimately lead us toward different or additional policy considerations," Ms. Lee wrote in the letter.

Write to Dave Michaels at dave.michaels@wsj.com

(END) Dow Jones Newswires

March 09, 2021 14:20 ET (19:20 GMT)

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