Investors and Congress are awaiting an imminent report from Securities and Exchange Commission Chair Gary Gensler on the GameStop/Robinhood/Reddit saga, as well as his recommendations on what, if any, changes should be made in the U.S. trading system.
Gensler has told Congress that his staff has been looking into both issues and promised a report by the end of summer on the following:
1) GameStop/Robinhood/Reddit: In January, investors in Reddit chatrooms and subreddits like WallStreetBets drove up the value of GameStop shares. Many of these trades occurred on Robinhood, which subsequently struggled to keep operating.
2) Market structure: Gensler has expressed concerns about several aspects of the U.S. trading system, specifically “gamification” of trading (trading with game-like features such as points, rewards, leaderboards, bonuses, and competitions to increase engagement). He also has spoken out about “payment for order flow,” or PFOF, in which brokers such as Charles Schwab send their orders to market makers in exchange for payments. This enables some brokers to charge zero commissions.
We sat down with Larry Tabb, head of market structure research for Bloomberg Intelligence, for help in understanding payment for order flow. This interview has been edited for clarity and brevity.
SEC Chair Gary Gensler has repeatedly expressed concern that payment for order flow is a problem for the markets and that banning it is “on the table.” Is the retail investor getting ripped off?
No. Retail investors are getting a much better deal than they have ever gotten. When I started in 1980, it cost $200 to get in on a trade, and $200 to get out, and you might not even get confirmation of the trade for a couple days. Today, commissions are at zero, so instead of $4.99 a trade in 2019, you’re paying nothing other than a small cost for the payment for order flow. Also, execution is way better than it used to be. The spread has tightened across the board.
Is payment for order flow a problem for the overall market?
It’s not a problem for retail investors. It might be a problem for institutional investors or other traders who want to trade against that retail order flow that can’t do it right now.
Why can’t they trade against it?
Because the bulk of the order flow goes to two main wholesalers, Citadel and Virtu.
What about those two wholesalers that dominate the market? Is that a problem?
Some will say yes, some will say no. The statistics don’t indicate it is a serious problem. On the other hand, it’s possible that other competitors might have been able to provide better execution on an individual order. But overall, it looks very competitive, and the retail investor seems to be getting a good deal.
What is the actual cost for payment for order flow to an individual investor?
We analyzed the reports filed by the brokers. The payment for order flow from the wholesaler to the retail broker is about 17 cents per 100 shares. The price improvement is 60 cents per 100 shares.
What does that mean for the retail investor?
It means the client is getting 60 cents per hundred shares better pricing than if they were trading at the best bid and offer. In addition, they are getting free execution. So essentially the commission has gone from $4.99, which was about the average commission price in September 2019, to 17 cents for PFOF.
These wholesalers say they provide price improvement. How is that done?
The wholesaler executes between the midpoint and the offer. The difference between what they execute at and the bid-offer spread is price improvement, and that’s what the investor saves, because they are getting a better price than what was displayed.
Give me an example.
Say you have a stock with a bid of $20 and an ask of $20.10 and someone wants to buy 100 shares. The midpoint is $20.05. The wholesaler might print at $20.08. The two cents between $20.08 and $20.10 is what the retail investor saves. The wholesaler captures three cents — the difference between the midpoint ($20.05) and what it was sold for ($20.08). Of that three cents, our research indicates the wholesaler would give back about 0.6 cents to the broker, and the wholesaler would make about 2.4 cents. That 0.6 cents paid to the broker cover the cost of the trade — there is no commission. So the client gets the two cents better execution, and they also get a free trade.
That doesn’t sound like a bad deal. Why is Gensler concerned about it?
There may be concerns from the competitors to Citadel and Virtu.
Who would that be?
It could be the stock exchanges, or market makers other than Citadel or Virtu who don’t have access to the liquidity.
Gensler has also said that he wants more competition in this space, but Citadel and Virtu claim they are providing price improvement and that there is competition.
Yes, and there are firms like Hudson River that have announced they are moving into the market as well.
How many brokers are getting paid for order flow?
There are about 12 major firms. The largest ones that pay are Schwab [which is Schwab, Ameritrade, and Ameritrade Clearing], Robinhood, and E-trade [now owned by Morgan Stanley]. TradeStation, Webull, Ally, and Apex Clearing also get paid.
But there are many more that don’t get paid, correct?
Yes. Big wirehouses like Citi, Bank of America/Merrill Lynch, and UBS don’t get paid.
One of the problems Gensler has with payment for order flow is that it takes trading away from the “lit” stock exchanges. Shouldn’t we be encouraging more trading on the exchanges?
Overall, yes, we should. More price discovery is good. The problem is that the exchanges are now for-profit. The revenue structure has migrated to a data business. There are many trading firms that feel they are being charged exorbitantly for that data.
Gensler’s argument is that too much of the order flow is not exposed to the broader market, and investors could be getting better prices if they were exposed to it. Is he right?
There are over a hundred places to execute an order. There are 16 exchanges, 32 dark pools, and 150 broker/dealers who internalize. Theoretically, if all that order flow was placed on the exchanges, the prices should tighten. The question is, would it tighten more than that 60-cent price improvement given to the investor, or would it tighten less? My belief is that if you push all the order flow onto an exchange, you would get price improvement, but it wouldn’t be as much as the retail investor is getting today. You would be getting a transfer of value from retail to institutions. So instead of 60 cents, you might only get 40 cents, and the other 20 cents would go to other traders.
Gensler has also noted that payment for order flow is illegal in many countries, like Canada.
He’s not exactly right. In Canada, they don’t have PFOF, but they have broker priority for retail orders, so the broker can cut into the line and trade ahead of everyone else who has been waiting. It’s like a dark pool. All he has to do is honor the best price. In general, I don’t think you should be comparing our markets to others. In the UK and Australia, it is much more expensive to own and trade stocks. The American economic fabric is based on people owning stock in companies. Individuals finance the growth of the economy, and our market is structured to make it efficient for individual investors to own stock.
What about the sub-penny rule? Right now, exchanges can’t trade in increments below a penny, but market makers like Citadel and Virtu can execute in sub-pennies.
That is an unfair competitive advantage to those wholesalers. There should be a level playing field, where everyone trades in, say, half-cent or quarter-cent intervals.
Is there any other reason why Gensler is concerned about this issue?
Congress has grilled him on this issue from day one, so it’s clearly an issue for them. It also got tied in with the GameStop issue.
What do you recommend should be done about payment for order flow?
First, the rules are a bit antiquated, so they should be updated. We need more disclosure. For example, the reports of wholesalers on how fast orders are filled should be updated. They also don’t include odd lots [orders of less than 100 shares]. They should also improve the benchmarks for pricing large orders. All of this would provide greater information so that investors can better understand how the orders are being executed. And as you increase disclosure it increases competition in the marketplace.
What’s the bottom line?
The U.S. market is very efficient. Banning PFOF would hurt retail investors and help institutions. We can improve the markets by providing more disclosure that would make the markets even more efficient without disadvantaging retail investors.