These concerns emerged Wednesday in a speech by the new chairman of the United States Securities and Exchange Commission, Gary Gensler. “The payment of order flow raises a number of important questions,” he said at a conference on financial markets. “Do brokers have inherent conflicts of interest? If so, are clients getting best execution in the context of this conflict? “

Gensler said he asked SEC staff to review order flow payments (and other controversies over market structure) and then propose the necessary rule changes.

To understand what this is about, it helps to know what goes on behind the scenes of a corporate action. When you place a trade order with a retail broker like Robinhood or

Charles Schwab

(ticker: SCHW) – say, to buy 100 shares of

AMC Entertainment Holdings

(AMC): The broker transmits this order to a trading venue, where it can be matched with orders from other traders looking to sell the stock.

Once upon a time, trading in a stock listed on the NYSE like AMC would take place on the New York Stock Exchange. In recent years, however, computerized market makers like Citadel Securities or

Virtu Financial

(VIRT) have taken a growing share of trading volume on exchanges like the NYSE (now part of

Intercontinental exchange

(ICE)), or

Nasdaq

(NADQ). In January 2021, Gensler told his audience, the exchanges handled around 53% of trades, while 38% were executed by market makers like Citadel Securities.

There are a number of factors brokers are expected to take into account when deciding where to route their clients’ orders for. best execution. Among these are the speed of execution, the probability of matching the entire order and, perhaps most importantly, the price per share obtained during the trade.

Market makers profit by paying less to buy a stock than they can sell it moments later. But they can compete for trading volume by ceding part of the spread to a broker and its clients. On Thursday, for example, the market’s best bid for 1,000 AMC shares was $ 42.87 per share, while the asking price for a similar amount was $ 43.78; leaving the spread on this volatile stock at 91 cents. Virtu’s documents indicate that it saved retail traders some $ 3 billion in 2020 in “price improvements,” by offering prices slightly better than the cited gap.

A more controversial way to get an order flow is to pay directly for it. Large market makers pay retail brokers hundreds of millions of dollars a year for their order flow. Documents filed by Virtu show that it spent $ 660 million in 2020 on order flow payments (including certain other market fees), as it generated some $ 2.5 billion in trading revenue. market. Monetizing order flow has always been a part of the business models of most retail brokers. That’s pretty much the entire business model of the future Robinhood. In the first quarter of 2021, documents filed by Robinhood show it received $ 331 million in order flow payments, up from $ 91 million the year before.

Retail brokers have always insisted that these order flow payments do not deter them from routing trades to markets where they will be best executed. They argue that the payouts helped subsidize the steady decline in trading commissions over the past two decades, Robinhood ultimately brought industry commissions down to zero.

But regulators haven’t always agreed that order flow payments benefit customers. In December, the SEC filed administrative charges alleging that Robinhood sent its clients’ orders to market makers who were trading at lower prices, in exchange for unusually high order flow payments from the makers. Steps. Even after factoring in Robinhood’s free commissions, its clients found themselves in a worse position by $ 34.1 million, the SEC said. Without admitting the SEC charges, Robinhood paid $ 65 million to settle the case and promised to improve its disclosure and enforcement. The broker had already settled regulatory action alleging poor execution of the transaction (without admitting the charges).

Market makers aren’t the only ones paying to attract orders. The exchanges offer discounts of different sizes for certain orders. An SEC pilot program to limit discounts was stalled last year when the exchanges were taken to court.

“The two types of payment for order flow raise questions about whether investors are getting best execution,” Gensler said in his speech on Wednesday.

In 2015, a pioneering work of data journalism in Barron presented the first-ever trade execution comparison between leading retail brokers and market makers. Market makers told us that they would gladly offer a broker’s clients better prices on trades in return for paying the broker less for the order flow. It was up to the broker to choose the trade-off between being able to get better prices per trade or order flow payments (which the broker could, in theory, use to subsidize lower commissions or other service improvements. ).

Market makers say the share of the spread they paid back as “price improvement” has, on average, continued to increase in recent years. However, the quoted prices that establish the spread of a stock are set in the exchanges that take place on the stock exchanges, and Gensler noted on Wednesday that those quotes may have become less meaningful benchmarks as the share of trade in trade volume decreases.

You can bet that in the coming months brokers, market makers, and exchanges will be busy trying to persuade the SEC that order flow payments can be good for retail traders.

Write to Bill Alpert at [email protected]