Gary Gensler from the SEC to report on GameStop and how brokerages are paid
Investors are bracing for an imminent report from Securities and Exchange Commission Chairman Gary Gensler on the GameStop / Robinhood / Reddit saga, along with his recommendations on what changes, if any, should be made to the U.S. trading system.
Gensler told Congress his team had looked into both issues and promised a report by the end of the summer on the following:
1) GameStop / Robinhood / Reddit: In January, investors in Reddit discussion forums and subreddits like WallStreetBets drove up the value of GameStop shares. A lot of those exchanges took place on Robinhood, which then struggled to keep running.
2) Market Structure: Gensler has expressed concerns about several aspects of the US trading system, in particular the ‘gamification’ of commerce (trading with gaming features such as points, rewards, leaderboards, bonuses and competitions to increase engagement). He also spoke about payment for order flow, in which brokers such as Charles Schwab send their orders to market makers in exchange for payments. This allows some brokers not to charge any commission.
We spoke with Larry Tabb, head of market structure research for Bloomberg Intelligence, to help us understand payment order flow. This interview has been edited for clarity and brevity.
SEC Chairman Gary Gensler has repeatedly expressed concern that payment for order flow is a problem for the markets and that its ban is “on the table.” Is the retail investor getting ripped off?
No. Retail investors are getting a much better deal than they ever have. When I started in 1980, it cost $ 200 to enter a trade and $ 200 to exit, and you might not even get transaction confirmation for a few days. Today the commissions are zero, so instead of $ 4.99 per transaction in 2019, you pay nothing but a small cost for the order flow payment. In addition, the execution is much better than before. The gap has narrowed at all levels.
Is payment for order flow a problem for the entire market?
This is not a problem for retail investors. This could be a problem for institutional investors or other traders who wish to trade against this retail order flow who cannot at this time.
Why can’t they trade for it?
Because most of the order flow goes to two main wholesalers, Citadel and Virtu.
What about these two wholesalers who dominate the market? Is it a problem?
Some will say yes, others will say no. Statistics do not indicate that this is a serious problem. On the other hand, it is possible that other competitors may have provided 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 of paying for the order flow to an individual investor?
We analyzed the reports filed by brokers. The payout for the order flow from wholesaler to retail broker is approximately 17 cents per 100 shares. The price improvement is 60 cents per 100 shares.
What does this mean for the retail investor?
This means that the client gets a better price of 60 cents per 100 shares than if they were trading at the best bid and ask price. Plus, they get free execution. So basically the commission went from $ 4.99, which roughly matched the average commission price in September 2019, to 17 cents for PFOF.
These wholesalers say they are improving the prices. How come ?
The wholesaler executes between the midpoint and the offer. The difference between what they’re running at and the bid-offer spread is the price improvement, and that’s what the investor saves because they get a better price than what was being displayed.
Give me an example.
Suppose you have a stock with a bid of $ 20 and a request of $ 20.10 and someone wants to buy 100 stocks. The midpoint is $ 20.05. The wholesaler could print at $ 20.08. The 2 cents between $ 20.08 and $ 20.10 is what the retail investor saves. The wholesaler captures 3 cents – the difference between the midpoint ($ 20.05) and the price at which it was sold ($ 20.08). Of those 3 cents, our research indicates that the wholesaler would return about 0.6 cents to the broker and the wholesaler would make about 2.4 cents. These 0.6 cents paid to the broker cover the cost of the transaction – there is no commission. So the client gets the best execution of 2 cents, and he also gets a free trade.
It doesn’t sound like a bad deal. Why does Gensler care?
There may be concerns from competitors of Citadel and Virtu.
Who would it be?
These may be stock exchanges, or market makers other than Citadelle or Virtu who do not have access to liquidity.
Gensler has also said he wants more competition in this space, but Citadel and Virtu say they are improving prices and there is competition.
Yes, and there are companies like Hudson River that have announced their entry into the market as well.
How many brokers are paid for the order flow?
There are about 12 large companies. The biggest paying are Schwab [which is Schwab, Ameritrade, and Ameritrade Clearing], Robinhood and E-commerce [now owned by Morgan Stanley]. TradeStation, Webull, Ally, and Apex Clearing are also paid.
But there are plenty more that don’t get paid, aren’t there?
Yes. Big wire houses like Citi, Bank of America / Merrill Lynch, and UBS don’t get paid.
One of the problems Gensler has with order flow payment is that it keeps trading away from “enlightened” exchanges. Shouldn’t we be encouraging more exchanges on the stock exchanges?
Overall, yes, we should. Plus the price discovery is good. The problem is that trading is now for profit. The revenue structure has migrated to a data business. Many commercial companies feel like they are being billed exorbitantly for this data.
Gensler’s argument is that too much of the order flow is not exposed to the broader market, and investors could get better prices if they were exposed to it. Is he right ?
There are over 100 places to fulfill an order. There are 16 exchanges, 32 dark pools and 150 brokers / traders who internalize. Theoretically, if all of this order flow was placed on the exchanges, prices should tighten. The question is whether it would tighten more than that 60 cent price improvement given to the investor, or would it tighten less? My belief is that if you move all of the order flow on an exchange, you will get price improvement, but it wouldn’t be as much as the retail investor gets today. You would get a transfer of value from retail to institutions. So instead of 60 cents, you might only get 40 cents, and the remaining 20 cents will go to other traders.
Gensler also noted that payment for order flow is illegal in many countries, such as Canada.
He’s not quite right. In Canada, they don’t have a PFOF, but they do have broker priority for retail orders, so the broker can cut the line and trade before anyone else who has waited. It’s like a dark pool. All that remains is to honor the best price. In general, I don’t think you should compare our markets to others. In the UK and Australia, it is much more expensive to own and trade stocks. America’s economic fabric is built on people owning shares in companies. Individuals finance the growth of the economy and our market is structured in such a way that it is efficient for individual investors to hold stocks.
What about the penny rule? At present, the exchanges cannot trade in increments of less than a penny, but market makers like Citadel and Virtu can execute in sub-pennies.
It is an unfair competitive advantage for these wholesalers. There should be a level playing field, where everyone exchanges, say, half a cent or quarter cent intervals.
Is there another reason Gensler is concerned about this issue?
Congress has grilled it on this issue from day one, so it’s clearly a problem for them. This has also been linked to the GameStop issue.
What do you recommend doing about the checkout flow payment?
First, the rules are a bit archaic, so they should be updated. We need more disclosure. For example, wholesalers’ reports on how quickly orders are filled need to be updated. They also do not include odd lots [orders of less than 100 shares]. They should also improve benchmarks for pricing large orders. All of this would provide more information so that investors can better understand how orders are executed. And as you increase disclosure, it increases competition in the market.
What is the result ?
The American 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 putting retail investors at a disadvantage.