Investors are awaiting an upcoming report on the Gamestop / Robinhood / Reddit story from Gary Gensler, chairman of the Congressional Securities and Exchange Commission, as well as his recommendations on what should be changed in the US trading system.
Gensler told Congress that his staff was looking into both issues and promised a report by the end of the summer:
1) Gamestop / Robinhood / Reddit: In January, investors in the Reddit chatroom and subredits like Wall StreetBates boosted the value of Gamestop shares. Many of these businesses happened in Robinhood, which later struggled to manage.
2) Market Structure: Gensler has expressed concern about various aspects of the US trading system, especially trading with “gamification” of trading (game-like features such as points, prizes, leaderboards, bonuses and competition to increase competition). He also talks about “paying for the flow of orders” or PFOF, where brokers like Charles Schwab send their orders to market makers in exchange for payment. This enables some brokers to take zero commission.
We sat down with Larry Tab, head of market structure research at Bloomberg Intelligence, to help pay for the flow of orders. This interview has been edited for clarity and brevity.
SEC Chair Gary Gensler has repeatedly expressed concern that paying for the flow of orders is a problem for the market and that banning it is “on the table”. Is the retail investor tearing up?
No. Retail investors are getting much better deals than before. When I started in 1980, it cost 200 200 to enter a trade, and 200 200 to exit, and you probably won’t even get a trade confirmation for a few days. Today, the commission is zero, so instead of 4. 4.99 in 2019, you’re paying nothing but a small expense to pay for the order flow. Also, the implementation is much better than before. The spread has solidified across the board.
Is paying for order flow a problem for the overall market?
This is not a problem for retail investors. This can be a problem for institutional investors or other traders who want to trade against this retail order flow which they cannot do right now.
Why can’t they do business against it?
Because the lion’s share of order flow goes to the two main wholesalers, Citadel and Vertu.
What will happen to those two wholesalers who dominate the market? Is it a problem?
Some will say yes, some will not. Statistics do not indicate that this is a serious problem. On the other hand, it is possible that other competitors may be able to perform better on a separate order. But overall, it looks very competitive, and retail investors seem to be getting a good deal.
What is the actual cost of paying for an individual investor’s order flow?
We have analyzed the reports filed by the brokers. Money for order flow from wholesaler to retail broker is 17 cents per 100 shares. The price improvement is 60 cents per 100 shares.
What does this mean for retail investors?
This means clients are getting a better price than 60 cents per hundred shares if they traded the best bids and offers. In addition, they are receiving free executions. So basically the commission went from $ 4.99, which was the average commission price in September 2019, to 17 cents for PFOF.
These wholesalers say they offer price improvements. How is it done?
The wholesaler works between midpoint and offer. The difference between what they perform and the spread of the bid-offer is price improvement, and investors save because they are getting better prices than what was shown.
Give me an example.
Say you have a bid of 20 20 and a stock of. 20.10 and someone wants to buy 100 shares. Midpoint 20.05. Wholesalers can print at .0 20.08. Two cents between $ 20.08 and $ 20.10 that retail investors save. The wholesaler captures three cents – the difference between the midpoint ($ 20.05) and what was sold ($ 20.08). Of those three cents, our research indicates that the wholesaler will return about 0.6 cents to the broker, and the wholesaler will return about 2.4 cents. The 0.6 cents paid to the broker covers the cost of the trade – no commission. So the client gets two cents better execution, and they also get a free trade.
It doesn’t sound like a bad deal. Why is Gensler worried about it?
Competitors may have concerns about Citadel and Vertu.
Who will be?
It could be a stock exchange, or a market maker other than Citadel or Vertu that does not have access to liquidity.
Gensler further said he wants more competition in the space, but Citadel and Vertu claim they are improving prices and there is competition.
Yes, and companies like Hudson River have announced that they are moving to the market as well.
How many brokers are paying for the flow of orders?
There are about 12 large companies here. The biggest ones that provide are Schwab [which is Schwab, Ameritrade, and Ameritrade Clearing], Robinhood, and e-trade [now owned by Morgan Stanley]. TradeStation, Webul, Alley and Apex Clearing are also paid.
But there are many more who don’t get paid, right?
Yes. Big warehouses like Citi, Bank of America / Merrill Lynch, and UBS don’t get paid.
One of Gensler’s problems with payments for order flows is that it takes trading away from the “lit” stock exchange. Shouldn’t we encourage more trading on the exchanges?
Overall, yes, we should. More value discovery is better. The problem is that the exchanges are now for profit. The revenue structure has shifted to a data business. There are many trading firms who feel that they are being overcharged for this data.
Gensler argues that order flows are not exposed to much wider markets, and that investors can get better prices if they are exposed to them. Is she right
There are hundreds of places to place orders. There are 16 exchanges, 32 dark pools and 150 brokers / dealers who operate internally. Theoretically, if all order flows are placed on exchanges, prices should be tightened. The question is, will it be harder, or less, than the 60 percent price improvement offered by the investor? My belief is that if you push the flow of all orders towards the exchange, you will get a price improvement, but not as much as retail investors are getting today. You will transfer value from retail to institutions. So instead of 60 cents, you can get only 40 cents, and another 20 cents can go to other traders.
Gensler further noted that in many countries, such as Canada, it is illegal to pay for the flow of orders.
He is absolutely not right. In Canada, they don’t have PFOF, but their brokers have priority for retail orders, so brokers can cut the line and trade ahead of everyone else waiting. It is like a dark pond. All he has to do is honor the best price. In general, I don’t think you should compare our market with others. In the UK and Australia, owning and trading stocks is much more expensive. Based on stock owners in American economic fabric companies. Individuals finance the growth of the economy and our market is formed to make it efficient for individual investors to own stock.
What about the sub-penny rule? At the moment, exchanges cannot trade in increments below one rupee, but market makers like Citadel and Vertu can execute in sub-pennies.
That is an unfair competitive advantage for wholesalers. There should be a level playing field, where everyone trades at half or quarter intervals.
Is there any other reason for Gensler to be concerned about this problem?
Congress has grilled him on this from day one, so it’s obviously a problem for them. It also deals with the gamestop issue.
What recommendations should you make regarding payment for order flow?
First, the rules are a bit old, so they should be updated. We need more disclosure. For example, wholesalers should update reports on how quickly orders are fulfilled. They do not include strange lots [orders of less than 100 shares]. Their criteria for pricing large orders should also be improved. All of this will provide more information so that investors have a better understanding of how orders are being executed. And as you increase exposure it increases competition in the market.
What is the bottom line?
The US market is very efficient. Banning PFOFs will hurt retail investors and help institutions. We can improve the market through more disclosure without the hassle of retail investors which will make the markets more efficient.