SEC must find a way to limit payment to order flow

Financial Services Updates

The author is a former president of the Federal Deposit Insurance Corporation of the United States.

Securities and Exchange Commission Chairman Gary Gensler shed light on the practice of brokers selling their retail orders to market makers outside of regulated public exchanges.

These are usually “dark pools” – private exchanges managed by large financial institutions – or “wholesalers” such as Citadel and Virtu who execute orders internally.

Critics say payment for order flow, or PFOF, represents an inherent conflict of interest, wisely observing that brokers should get orders where they can get the best price for their clients, not the best deal for them. themselves.

Proponents argue that the PFOF benefits retail investors, as market makers are required to provide better prices than quotations posted by regulated exchanges. They add that the profits of PFOF brokers allow them to offer commission-free transactions.

But it is far from clear whether PFOF actually cuts costs for retail investors or simply makes their costs less transparent. By allowing market makers to attract the order flow with a bribe, not a better price, PFOF gives them every incentive to hide the true price they are willing to trade at, which probably leads to to poorer executions for retail traders.

Unlike market makers on public exchanges, dark pools and wholesalers are not required to publish and support quotes. When paying for an order, they have the discretion to negotiate against it or send it to an exchange.

While forex market makers must improve a published price by a dime, there is no such requirement for dark pools and wholesalers, who can and “improve” the price by a tiny fraction of a cent. .

Thus, PFOF gives them the luxury of not having to compete on price to attract the flow of orders, and to put themselves ahead of those who do, with minimal price improvement.

This lessens competition, but also creates a deterrent for others to publicly expose their business interests, knowing that dark pools and wholesalers can so easily – and cheaply – get ahead of them.

The relationship between PFOF and price quality was clearly illustrated in a recent enforcement settlement brought by the SEC against Robinhood. In this case, Robinhood explicitly agreed to accept less price improvements for its customers in exchange for a higher PFOF. The lower executions awarded to these Robinhood clients may well have exceeded any benefit of not paying commission.

The UK’s Financial Services Authority long ago wisely acknowledged the damage PFOF has done to the quality and integrity of the market, effectively banning it in 2012. A study by the CFA Institute of UK Markets revealed that in the absence of PFOF, markets were more liquid and prices improved for retail investors.

The reason is simple: when market makers have to compete on the quality of their public quotes and are rewarded with transactions on those quotes, they compete more aggressively. The incentives are aligned.

Ironically, Bernard Madoff of the fame of the Ponzi scheme, pioneered the use of PFOF in the 1980s, arguing with the SEC that he to augment competition for stock exchanges, then dominated by the NYSE. The foreign exchange market share has indeed barely halved, but concentrations have accumulated off-exchange.

Wholesalers now account for 38 percent of trade volumes in the United States, mainly dominated by seven companies. The market share of retail orders is even more concentrated, with Citadel accounting for 47 percent. This market dominance brings enormous benefits to Citadel, including a privileged first glimpse into retail order flow – a force that is increasingly moving stock prices, as we’ve seen recently with GameStop and other memes stocks.

Gensler said a number of market structure reforms were on the table, including banning PFOF. This can be difficult, as many “free” brokers might start charging commissions again to make up for lost income. This would be unpopular with retail investors who also vote and donate politically. However, the return of commissions is not a foregone conclusion. Brokers such as Fidelity are able to offer commission-free transactions without resorting to PFOF.

PFOF serves as an additional reminder for all regulators to carefully consider programs that are purportedly beneficial to the little guy. History is full of them. Madoff will be forever remembered for his multibillion dollar Ponzi scheme, but his most impactful legacy could be the damage done to investors by PFOF. Hopefully the SEC can find a way to work things out.

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