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The
U.S. Securities and Exchange Commission (SEC) is scrutinizing
the practice of payment-for-order-flow (PFOF), in which
wholesale market-markers pay brokers like TD Ameritrade,
Robinhood Markets and E*Trade to route retail customer orders to
them instead of to exchanges. The SEC review could lead to the
biggest shake-up of U.S. equity market rules in over a decade.
Robinhood makes around 75% of its revenue from PFOF. The trading
app and others say the practice on average gives retail
investors a fractionally better deal than exchanges, allowing
them to drop commissions and democratize investing.
Critics say payment for order flow can create conflicts of
interest, and also encourages brokers to add video game-like
bells and whistles to their apps and websites that prompt
investors to trade more, which boosts the broker's profit but is
rarely the best investment strategy. Britain, Canada and
Australia have banned PFOF and Gensler suggested in August that
the SEC could go that route.
PFOF drew new scrutiny last year when an army of retail
investors went on a buying spree of "meme stocks" like GameStop
and AMC, squeezing hedge funds that had shorted the shares. Many
purchased the shares using commission-free brokers like
Robinhood that accept PFOF from a few powerful market-makers.
The largest, Citadel Securities, says it controls 35% to 40% of
all U.S. retail order flow. Virtu Financial controls about 25%,
according to an analysis of SEC data by BestEx Research.
The SEC is exploring whether retail brokers are sending PFOF
customer orders to the wholesaler paying them the most, rather
than the venue that offers the best deal.
"When one party is paying a platform for the order flow, that
can be in conflict with a retail customer getting best
execution," SEC chair Gensler said in an interview. "They're not
getting order-by-order competition."
Some brokers, like Fidelity, say they can get good stock prices
for customers and offer free stock trading without accepting
PFOF.
A Robinhood spokeswoman pointed to a study by two Massachusetts
Institute of Technology professors who found Robinhood customers
enjoyed more than $8 billion in price improvements from
2020-2021 thanks to PFOF.
A spokesperson for TD Ameritrade said the current market
structure delivers "great outcomes" for investors and the
company supports efforts to make it even better.
A PFOF ban is on the table, Gensler told Reuters, but he said
the practice is also just a symptom of a broader problem:
exchanges are not competing on an equal footing with the
off-exchange market, where around 40%-50% of trading takes
place.
The national benchmark for measuring the best deal is flawed
because it does not include these off-exchange trades, he added.
"Here's the focus around new market structure rules: How might
we promote a more level playing field?," Gensler said.
The SEC is also mulling making it easier for exchanges to
compete with market-makers for orders by allowing exchanges to
offer sub-penny pricing, and by changing the definition of "best
execution," said Gensler and other industry executives.
Several executives said they doubted the SEC would actually ban
PFOF. Virtu Financial CEO Doug Cifu said his firm would be one
of many to challenge such a move in court.
"PFOF and rebates have really fostered incredible innovation and
competition in the marketplace," Cifu told Reuters, adding that
if the SEC bans the practice "they are looking at a very long
fight."
He and other industry executives said the SEC should enhance
retail brokers' disclosures so small investors are better
informed on the pros and cons of PFOF. Gensler said the SEC was
also reviewing disclosures.
"As long as it is transparent and disclosed, I don't see a
conflict," said Kirsten Wegner, CEO of the Modern Markets
Initiative which represents automated trading firms.
COMPETITIVE BOOST
Investor advocates support better disclosures and also want to
boost exchanges' competitiveness to improve the reliability of
the national pricing benchmark, known as the National Best Bid
and Offer (NBBO).
Current "best execution" rules require retail brokers to route
customer orders to a venue offering the best price displayed on
the exchange, or better, and market-makers typically improve on
the best price by a fraction of a cent.
Exchanges cannot offer sub-penny quotes, but the SEC is
considering allowing it. It is also mulling a rule, similar to
one in Canada, requiring retail brokers to execute orders on an
exchange unless the off-exchange price is significantly better,
said Dave Lauer, CEO of financial platform Urvin Finance, and
one other industry source with knowledge of the SEC's thinking.
Wholesalers provide a 15% improvement on the NBBO spread, but
moving retail flow to exchanges would narrow NBBO spreads by
25%, according to research by Hitesh Mittal, CEO of BestEx
Research.
"Institutional investors and market makers would better compete
with exchanges for retail flow by narrowing the bid offer
spread," he said.
Ty Gellasch, executive director of investor trade Healthy
Markets who has also discussed the issue with the SEC, said he
expects the agency to clarify that "best execution" requires
brokers to obtain the best available price rather than a
fractional price improvement.
"I expect it will say to the industry: 'you have to give the
customers the best prices,'" he said.
(Reporting by Katanga Johnson in Washington and John McCrank in
New York; Editing by Michelle Price and David Gregorio)
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