Payment for Order Flows
What Is Payment For Order Flows?
Payment for order flows refers to a practice where wholesale market makers pay brokers after the execution of a trade. It is usually in the form of a fraction of a penny for every share traded. This is according to SEC when specialists receive client orders for execution from brokers, brokers then acquire some of these profits through payment for order flows.
The practice has concerned regulators, including the US congress. The biggest concern emanates from the probability of a conflict of interest between firms and customers. Frequent trading by customers means more profit when dealers sell order flows. Why then shouldn't firms prod customers to trade more?
Additionally, brokers may fall for incentives to sell customer orders to the highest bidder. This disadvantages trading venues and market makers, offering the fastest execution and best prices.
Nowadays, traditional exchange environments don't account for every performance of trades. As such, investors might not get all information about price discovery from market makers.
Other market makers and online traders have also criticized the practice. This is because, through it, brokerage firms bypass online traders and other market makers.
The other reason for this outrage is because brokerage firms have eliminated commissions they charge for retail trades online. Notherntrust.com recognizes the practice has been in existence for years. However, under SEC rule 606, customers have to be aware of the arrangement.
The Security and Exchanges Commission (SEC) Stand
According to the SEC, the entire elimination of the payment for order flows "is on the table." It states that the practice is controversial since trading brokers and brokerage firms have made billions from it.
SEC chairperson, Gary Gensler, believes that small spreads aren’t all the benefits brokers get from the payment for order flows practice. According to him, they acquire the data and are the first to look and merge sellers to buyers out of these orders. He went on to add that that this reduces the efficiency of markets in this day and age.
However, according to Gensler, there wasn't evidence of harming investors by these conflicts of interest, states Barrons.com. He went on to state it was imperative to increase transparency in the market. This was because Canada, Australia, and the UK have forbidden order flows which reduce market efficiency.
The SEC is considering other dynamics of the market, including:
Internalization of a trade by companies that keep them off exchanges
The opaqueness of markets – meaning when market makers make more, investors make less after selling or buy at a higher price
Reshuffling of the processing and tracking of trades
According to Barrons, the practice makes a relatively small set of brokers’ business model. They estimate this to be at ten percent or less of revenue. Retrospectively, payment for order flows makes up more than 80% of Robinhood Markets’ revenue. This firm pioneered zero percent trading.
The announcement by the SEC chairman led to a drop in Robinhood shares, according to CNBC. After Gensler's proposal to ban payment for order flows, the shares dropped by 6.9% to 43.64 dollars per share.