By Alexander Osipovich
The Reddit-fueled frenzy in stocks such as GameStop Corp. and
AMC Entertainment Holdings Inc. is prompting calls for regulators
to reconsider a decades-old practice in the U.S. stock market:
payment for order flow.
The practice, in which high-speed trading firms pay brokerages
for the right to execute orders submitted by mom-and-pop investors,
has long been controversial. Some say it warps the incentives of
brokers and encourages them to maximize their revenue at the
expense of customers. Supporters, including many brokers and
trading firms, say it is misunderstood and helps ensure that
investors get seamless executions and good prices on their
trades.
Either way, it is big money. Last year, brokerages such as
Charles Schwab Corp., TD Ameritrade, Robinhood Markets Inc. and
E*Trade collected nearly $2.6 billion in payments for stock and
option orders, according to an analysis of company filings by JMP
Securities. The biggest sources of the payments were electronic
trading firms such as Citadel Securities, Susquehanna International
Group LLP and Virtu Financial Inc.
Payment for order flow helped set the stage for the manic
trading in GameStop, whose shares began the year around $18, surged
to a record close of $347.51 on Jan. 27 and ended Wednesday's
session at $92.41.
That is because payment for order flow made it possible for the
U.S. brokerage industry to shift to zero-commission trades in late
2019. No longer needing to pay a fee on stock transactions and
empowered by easy-to-use trading apps like Robinhood, individual
investors poured into stocks and options at record levels last
year. More recently, they snapped up stocks like GameStop that were
being touted on Reddit and other social-media platforms.
The simmering debate over payment for order flow boiled over
last week after some brokerages restricted trading in GameStop,
sparking heated speculation that the curbs were imposed at the
behest of giant trading firms that handle those brokers' order
flow. Trading firms like Citadel Securities denied being behind the
curbs, which in fact were prompted by brokers' need to post
additional collateral. Still, criticism of payment for order flow
has grown since then, coming from business leaders, politicians and
some smaller brokerage firms.
"Payment for order flow, at the end of the day, is legalized
bribery that appears to incentivize brokers to violate rules," said
Dennis Kelleher, president of Better Markets, an advocacy group
that lobbies for tighter financial regulations.
Public.com, a startup that offers an investing app that competes
with Robinhood, said Monday that it would no longer accept payment
for order flow. "It has become abundantly clear that staying true
to our mission requires that our incentives align more closely with
those of our community members," the company's co-founders said in
a written statement.
Some Silicon Valley investors, including Benchmark Capital
partner Bill Gurley and the billionaire former Facebook Inc.
executive Chamath Palihapitiya, attacked payment for order flow on
Twitter. Mr. Gurley urged the Securities and Exchange Commission to
end the practice, writing on Sunday: "If the SEC/government wants
to 'fix the plumbing' the number one thing they should do is ban
Payment for Order Flow."
Payment for order flow is likely to come up at a House Financial
Services Committee hearing on Feb. 18 devoted to the GameStop
episode, said Rep. Al Green (D., Texas), a member of the committee.
"The question we have to ask ourselves is...Does this inherently
create some conflict of interest?" he said in an interview.
Adding to the checkered reputation of payment for order flow,
one of its early practitioners was Bernie Madoff, who helped
pioneer the practice at his firm, Bernard L. Madoff Investment
Securities, years before his conviction for running a
multibillion-dollar Ponzi scheme.
And in December, Robinhood agreed to pay $65 million to settle
SEC allegations that it misled customers about its reliance on
payment for order flow and touted its execution quality while
filling orders at inferior prices. Robinhood didn't admit
wrongdoing.
The SEC has reviewed payment for order flow several times since
the 1990s and repeatedly condoned the practice, while requiring
brokers to release public disclosures on where they are routing
orders and what they are being paid.
Proponents of payment for order flow say it benefits investors
because it allows mom-and-pop investors to get better prices for
their trades than if the orders were sent to public markets such as
the New York Stock Exchange and the Nasdaq Stock Market.
"If you ban payment for order flow, the individual investor is
going to be worse off," said Robert Battalio, a finance professor
at the University of Notre Dame.
That is because of what brokers call price improvement -- when
an investor's order is filled at a price slightly better than what
is available on an exchange. For instance, suppose Apple Inc.
shares can be bought for $135.01 each or sold for $135 at Nasdaq.
An investor selling 100 shares of Apple could earn $13,500 if the
order was executed on the exchange. But if the investor's sell
order were routed to a trading firm such as Citadel Securities or
Virtu, the firm could buy the shares for a fraction of a penny per
share higher than $135, and the investor would get more money --
say, $13,505 instead of $13,500.
While such differences might seem small, they add up. Last year,
investors saved about $3.7 billion on their stock trades thanks to
price improvement, according to Bloomberg Intelligence.
Trading firms say they compete to provide the most price
improvement to brokers. "The magnitude of the orders routed to us
reflects the confidence of the retail brokerage community in our
systems engineering, reliability, balance sheet and execution
quality," said Joe Mecane, head of execution services at Citadel
Securities.
Eliminating payment for order flow would create its own
difficulties. Potentially, the SEC could prohibit the payments and
require investors' orders to be routed to exchanges, rather than
being privately executed by electronic trading firms. But that
would make it harder for brokerages to offer their customers
zero-commission trades, and it is unclear that investors would get
a better deal on exchanges.
Some industry veterans expect little to change. "The odds are
very low that payment for order flow will be banned," said Jamie
Selway, a former executive with brokerage Investment Technology
Group Inc. "It's a practice that reflects economic realities, and
it benefits retail investors in the form of low commissions."
Write to Alexander Osipovich at
alexander.osipovich@dowjones.com
(END) Dow Jones Newswires
February 04, 2021 05:44 ET (10:44 GMT)
Copyright (c) 2021 Dow Jones & Company, Inc.
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