Payment for Order Flow
A U.S. retail investor sends out an order to buy or sell a stock through a brokerage account. She may think her trade heads directly to the New York Stock Exchange, but that’s rarely true. Instead, electronic wholesale firms often end up carrying out those requests. In most cases, the firms pay retail brokers for the right to execute these customer trades in a widespread practice known as “payment for order flow.” It’s a system credited with lowering trading costs for mom-and-pop investors — but regulators wonder whether it’s ultimately in their best interest.
Two firms dominate the arena of carrying out retail trades: Citadel Securities and KCG Holdings. About one in five trades in the U.S. stock market are handled by wholesalers, according to research firm Tabb Group. But regulators have expressed some trepidation about broker payment systems. While they have not banned payment for order flow, regulators have called into question whether it presents conflicts of interest in how retail brokers route their customers’ trades. They’ve also warned about how brokers price customer orders, and differences between the fastest, priciest data feeds and their slower-moving counterparts. The U.S. Securities and Exchange Commission asked a committee of advisers whether the systems should be banned or altered — but hasn’t taken any steps yet to change the practice. Regulators are also taking a broader look at how individual investors’ trades get carried out. The SEC fined Citadel Securities $22.6 million in January, saying the firm inaccurately described how it handled trades placed by small investors.
Payments for order flow stretch back to the 1980s. Bernie Madoff (yes, that Bernie Madoff) was a pioneer in the field, paying firms like Charles Schwab and Fidelity a penny or two per share for the right to make their trades. Madoff’s firm could afford this back then because the New York Stock Exchange required a minimum markup of one-eighth of a dollar (12.5 cents) per share. Retail brokerages used the money collected from Madoff to lower the fees they charged clients. The end of fractions on the exchange allowed markup prices to fall, and the advent of electronic trading and regulatory changes helped the system spread. The largest wholesalers now pay just fractions of a penny for the right to trade a share and earn just fractions of a penny on the trade spread. These fractions add up — retail brokers can rake in tens or hundreds of millions of dollars from the payments annually. Wholesalers like to bundle orders from retail customers because they’re less likely to be super knowledgeable about the direction of the market than the big investment firms, thus reducing the chances that the wholesalers will lose money in the time they might hold the securities. Over the years, U.S. stock trading has shifted from the hands of big banks to leaner automated trading firms. Citadel agreed to purchase Citigroup’s Automated Trading Desk in May 2016, adding to its market-making muscle.
Retail brokers and trading firms say that the payment for order flow system is a win for retail customers, who have never been able to trade more cheaply. They argue that the payments help keep broker fees lower than they’d otherwise be. And they note the payouts are no secret: Any brokers that accept payments from trading firms must publicly disclose both how much they receive and how well customer trades were handled. Critics of the system argue that it sets up a conflict of interest, and that brokers may be tempted to funnel orders to the firms that dangle the most cash for their customer orders instead of firms that regularly trade for the best price. The U.K. cited this conflict of interest when it tightened regulations on payment for order flow in 2012. Among the harshest U.S. critics of the practice are former Senator Carl Levin, who called for an outright ban on the trading incentives, and Michael Lewis, who questioned the practice in his 2014 book “Flash Boys.” Under SEC rules, traders aren’t obliged to get the best price for clients, they’re obliged to get the “best execution,” which could include other factors like the speed of the trade. The Justice Department investigation is looking at whether the wholesalers are using different data reporting feeds to show that they are meeting the trade requirements.
- The Securities and Exchange Commission’s memo to its advisory committee on market structure.
- Bloomberg article on Senator Carl Levin’s 2014 letter calling for an end to stock market pricing models that create conflicts of interest for brokers.
- Michael Lewis’s 2014 book “Flash Boys” called payments to brokers a “wacky incentive.”
- CNN Money interviewed Bernie Madoff about payment for order flow in 2000, nine years before he pled guilty to running the largest Ponzi scheme in U.S. history.
First published May 20, 2016
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