Last week, the new chairman of the Securities and Exchange Commission, Gary Gensler, said he asked SEC staff to explore changes to the rules governing the processing of investor orders. The review will include a practice known as payment for order flow, in which brokerage firms send many orders from their clients to trading companies in exchange for cash payments. Virtu shares sold off strongly after Mr. Gensler’s remarks.

Paying for Order Flow has been around for decades and has already come under intense scrutiny. But it received new attention after the savage volatility of GameStop stocks in January. At a congressional hearing in February, Representative Sean Casten (D., Ill.) Called Robinhood Markets Inc.’s practice of sending orders to traders at high speed as “a channel to feed sharks fish. “.

Companies such as Robinhood and Virtu claim that payment for the order flow is poorly understood. They say small investors benefit from this practice because it results in better prices than they would get on public exchanges like the New York Stock Exchange and the Nasdaq Stock Market..

Collectively, this saves investors billions of dollars a year, according to industry data.

Paying for order flows has also enabled brokerage firms to conduct commission-free transactions. If the practice were banned, it is not clear whether brokerage houses like Robinhood could still let investors trade stocks and options without charging commissions.

Virtu Managing Director Douglas Cifu has been one of the most vocal advocates of Order Flow Payment. In March, shocked by comments from CNBC “Squawk Box” host Andrew Ross Sorkin about how high-speed traders took advantage of investor orders, Mr. Cifu tweeted his phone number to Mr. Sorkin and said: “Let me know when you want to learn how the markets work. Soon after, the CEO went to the show to discuss payment for the order flow with Mr. Sorkin.

In an interview, Cifu warned that banning the practice and requiring that individual investor orders be sent to exchanges would hurt small investors. “Retail investors would get a much, much worse experience,” he told The Wall Street Journal.

Companies like Virtu, known in the trade as wholesalers, make money from investors by filling their orders throughout the day and collecting a small spread between the buy and sell price of each. action. Under SEC rules, they cannot enter into transactions at prices lower than the best available price on the exchanges, a benchmark known as the best offer or national offer, or NBBO.

Since individuals tend to do small transactions, wholesalers can trade against them knowing that individuals are not likely to move stock prices up or down, in the same way that institutional investors can move a stock. through large purchases or sales. This allows wholesalers to earn more consistent profits when filling orders from small investors than when trading on the stock exchange, a benefit they are willing to pay brokers for, in the form of payment for the order flow.

Meanwhile, small investors can benefit from the arrangement by getting better prices than the NBBO, often at a fraction of a dime per share.

The resulting savings for the investor are called “price improvement”. In a report released Thursday, Virtu said standard analyzes underestimate the extent to which small investors benefit from wholesalers’ order fulfillment.

Using a larger-than-usual pricing improvement measure, Virtu said it saved investors just over $ 3 billion on their stock transactions in 2020. By comparison, data disclosed by wholesalers under SEC reporting rules show that Virtu provided around $ 950 million in price improvement. Last year.

The difference was largely due to the way Virtu calculated the savings when an investor makes a trade larger than what is publicly displayed on the exchanges. For example, suppose 200 shares of Apple Inc.

are available on the stock exchange at the best national price, and an investor buys 500 Virtu shares at a slightly lower price.

In this scenario, Virtu’s methodology counts the savings based on the cost of purchasing the 500 stocks using the stock exchange quotes – not just at the best domestic offer, a price at which only 200 stocks are listed, but at most. high price where the remaining 300 shares would be filled.

Critics were not convinced by Virtu’s analysis, calling her selfish. Paying order flow is fundamentally flawed because it poses a conflict of interest for brokers, said Tyler Gellasch, executive director of the Healthy Markets Association, a trading group for institutional investors.

“There is a simple question every investor should ask themselves, and that is whether their broker is trying to get them the best prices or to maximize their own profits,” said Mr. Gellasch.

Virtu is the second-largest wholesaler in the U.S. stock market by volume, handling between 25% and 30% of individual investor order flow, and it paid more than $ 300 million for the order flow last year, according to Bloomberg Intelligence.

Other major wholesalers include Citadel Securities, which has the largest market share, and Susquehanna International Group LLP. Virtu doesn’t say how much he earns trading against small investors, but the meme stock frenzy has helped the company’s stock increase by 15% since the start of the year.

Mr Cifu acknowledged that paying for the flow of orders poses a conflict of interest for brokerage firms, but said the conflict was already handled by SEC rules. The regulator requires brokerage firms to publicly disclose their payment practices for order flow. Brokerages also have a duty to seek best execution for their clients, and some have been fined for failing to fulfill this obligation when routing orders.

The SEC review will ultimately confirm that the stock market is working well for small investors, Cifu predicted.

“I’m so confident in the value that we, Citadel and Susquehanna in partnership with these retail brokers have brought to the ecosystem,” he said, “anyone in their right mind looking at this and reviewing the data will conclude:” Man, this is a great trading system. It is the envy of the world.

Write to Alexandre Osipovich at [email protected]