By Alexander Osipovich 

The Reddit-fueled frenzy in stocks such as GameStop Corp. and AMC Entertainment Holdings Inc. is prompting calls for regulators to reconsider a decades-old practice in the U.S. stock market: payment for order flow.

The practice, in which high-speed trading firms pay brokerages for the right to execute orders submitted by mom-and-pop investors, has long been controversial. Some say it warps the incentives of brokers and encourages them to maximize their revenue at the expense of customers. Supporters, including many brokers and trading firms, say it is misunderstood and helps ensure that investors get seamless executions and good prices on their trades.

Either way, it is big money. Last year, brokerages such as Charles Schwab Corp., TD Ameritrade, Robinhood Markets Inc. and E*Trade collected nearly $2.6 billion in payments for stock and option orders, according to an analysis of company filings by JMP Securities. The biggest sources of the payments were electronic trading firms such as Citadel Securities, Susquehanna International Group LLP and Virtu Financial Inc.

Payment for order flow helped set the stage for the manic trading in GameStop, whose shares began the year around $18, surged to a record close of $347.51 on Jan. 27 and ended Wednesday's session at $92.41.

That is because payment for order flow made it possible for the U.S. brokerage industry to shift to zero-commission trades in late 2019. No longer needing to pay a fee on stock transactions and empowered by easy-to-use trading apps like Robinhood, individual investors poured into stocks and options at record levels last year. More recently, they snapped up stocks like GameStop that were being touted on Reddit and other social-media platforms.

The simmering debate over payment for order flow boiled over last week after some brokerages restricted trading in GameStop, sparking heated speculation that the curbs were imposed at the behest of giant trading firms that handle those brokers' order flow. Trading firms like Citadel Securities denied being behind the curbs, which in fact were prompted by brokers' need to post additional collateral. Still, criticism of payment for order flow has grown since then, coming from business leaders, politicians and some smaller brokerage firms.

"Payment for order flow, at the end of the day, is legalized bribery that appears to incentivize brokers to violate rules," said Dennis Kelleher, president of Better Markets, an advocacy group that lobbies for tighter financial regulations.

Public.com, a startup that offers an investing app that competes with Robinhood, said Monday that it would no longer accept payment for order flow. "It has become abundantly clear that staying true to our mission requires that our incentives align more closely with those of our community members," the company's co-founders said in a written statement.

Some Silicon Valley investors, including Benchmark Capital partner Bill Gurley and the billionaire former Facebook Inc. executive Chamath Palihapitiya, attacked payment for order flow on Twitter. Mr. Gurley urged the Securities and Exchange Commission to end the practice, writing on Sunday: "If the SEC/government wants to 'fix the plumbing' the number one thing they should do is ban Payment for Order Flow."

Payment for order flow is likely to come up at a House Financial Services Committee hearing on Feb. 18 devoted to the GameStop episode, said Rep. Al Green (D., Texas), a member of the committee. "The question we have to ask ourselves is...Does this inherently create some conflict of interest?" he said in an interview.

Adding to the checkered reputation of payment for order flow, one of its early practitioners was Bernie Madoff, who helped pioneer the practice at his firm, Bernard L. Madoff Investment Securities, years before his conviction for running a multibillion-dollar Ponzi scheme.

And in December, Robinhood agreed to pay $65 million to settle SEC allegations that it misled customers about its reliance on payment for order flow and touted its execution quality while filling orders at inferior prices. Robinhood didn't admit wrongdoing.

The SEC has reviewed payment for order flow several times since the 1990s and repeatedly condoned the practice, while requiring brokers to release public disclosures on where they are routing orders and what they are being paid.

Proponents of payment for order flow say it benefits investors because it allows mom-and-pop investors to get better prices for their trades than if the orders were sent to public markets such as the New York Stock Exchange and the Nasdaq Stock Market.

"If you ban payment for order flow, the individual investor is going to be worse off," said Robert Battalio, a finance professor at the University of Notre Dame.

That is because of what brokers call price improvement -- when an investor's order is filled at a price slightly better than what is available on an exchange. For instance, suppose Apple Inc. shares can be bought for $135.01 each or sold for $135 at Nasdaq. An investor selling 100 shares of Apple could earn $13,500 if the order was executed on the exchange. But if the investor's sell order were routed to a trading firm such as Citadel Securities or Virtu, the firm could buy the shares for a fraction of a penny per share higher than $135, and the investor would get more money -- say, $13,505 instead of $13,500.

While such differences might seem small, they add up. Last year, investors saved about $3.7 billion on their stock trades thanks to price improvement, according to Bloomberg Intelligence.

Trading firms say they compete to provide the most price improvement to brokers. "The magnitude of the orders routed to us reflects the confidence of the retail brokerage community in our systems engineering, reliability, balance sheet and execution quality," said Joe Mecane, head of execution services at Citadel Securities.

Eliminating payment for order flow would create its own difficulties. Potentially, the SEC could prohibit the payments and require investors' orders to be routed to exchanges, rather than being privately executed by electronic trading firms. But that would make it harder for brokerages to offer their customers zero-commission trades, and it is unclear that investors would get a better deal on exchanges.

Some industry veterans expect little to change. "The odds are very low that payment for order flow will be banned," said Jamie Selway, a former executive with brokerage Investment Technology Group Inc. "It's a practice that reflects economic realities, and it benefits retail investors in the form of low commissions."

Write to Alexander Osipovich at alexander.osipovich@dowjones.com

 

(END) Dow Jones Newswires

February 04, 2021 05:44 ET (10:44 GMT)

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