QuickTake Q&A: Why Payments for Stock Trades Face More Scrutiny

U.S. regulators are looking at whether mom-and-pop traders are getting a raw deal. The Justice Department and New York attorney general are said to be investigating a widespread practice known as “payment for order flow,” in which brokers sell their clients’ stock-trade orders to market-making firms.

1. Can you explain this?

About a third of U.S. stock trading never reaches a public exchange. It’s handled in dark pools — private stock markets inside some of Wall Street’s biggest banks — or through wholesale market makers, which pay brokerages to bring them business. Market rules require brokers to get the best possible prices for customers, and to disclose any payments for routing order flow. Brokers using the system, including TD Ameritrade Holding Corp., E*Trade Financial Corp. and Charles Schwab Corp., earn hundreds of millions of dollars a year from the practice. They say it helps bring down trading costs for retail customers.

2. How is it likely to play out?

The two separate inquiries have brought renewed attention to the decades-old system, which has been the target of scrutiny from lawmakers and the U.S. Securities and Exchange Commission. Citadel Securities and KCG Holdings, the two largest wholesalers, have been sent subpoenas and requests for information. The SEC has asked a committee of advisers whether the incentive system should be changed or prohibited.

3. Who is worked up about this?

Former Michigan Senator Carl Levin and author Michael Lewis are
among those who have questioned whether the practice is a giant conflict of interest. Lewis, in “Flash Boys,” called the payments to brokers a “wacky incentive.” At the heart of the dispute is whether brokers can really serve the best interest of their customers when they’re sending orders to the market makers that reward them most generously.

4. Could there be a surprise here?

If the current system really does lower trading costs for retail customers, and regulators demand changes to disrupt it, it’s conceivable that mom-and-pop investors could end up paying more for stock trades, or getting worse prices.

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