“Payment by order flow” to make a check

With a focus on Robinhood, GameStop, and retailers at Thursday’s hearings, trading volumes are very focused, as is the practice of “order flow payment”.

Talk about a story back.

A year ago, retailers were a declining part of the business world. Then Covid hit.

Millions of people stayed home and got stimulus checks. They went online. With sports almost closed, many first looked at retail trading.

In December 2019, retail operations averaged 13% of the total volume of trading shares, according to data from Piper Sandler. By the end of December 2020, the figure had almost doubled, to 22.8%.

And retailers are engaged in addition to their fair share of bargaining.

“Not only did it increase the share of retail trade, but it increased volumes a lot more,” said Rich Repetto, who tracks trading with Piper Sandler. Global trade in 2020 increased by 55% compared to 2019, noted Repetto, largely driven by retailers.

And the trend continues until 2021. The average annual daily volumes to date are 42% higher than in 2020, although Repetto noted that the volumes of the first quarter are usually higher than the rest of the year .

This increase in retail trade has led to greater control for a practice known as “payment for order flow” whereby some brokers receive payments from market makers (distributors) to route them to operations.

Most retail is not done on stock exchanges, but by market makers who “internalize” operations.

This is how it works. Suppose you want to buy 100 shares of Tesla. When you press the button on a transaction, you have given your agent a purchase order for 100 Tesla shares at market price.

Normally, your broker will have a pre-established agreement with the market makers who will compete for the order flow. Major market makers include Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma and UBS.

Virtu CEO Doug Cifu said his company is fiercely competing for this order flow: “Most brokers have a‘ routing wheel ’and, within that wheel, they will send customer orders to those responsible. of the market based on the amount of price improvement they have provided., “he said.

Cifu noted that the order flow payment rate varies from agent to agent, but is usually set within the broker. A broker can charge 10 cents for every 100 shares, for example. Others may charge more, others nothing.

The key point, Cifu says, is that Virtu and other companies must meet the best enforcement obligations, which typically include price improvements.

We return to the Tesla trade, to buy 100 shares. Suppose the offer (what a buyer was willing to pay) was $ 792.80, the question (what a seller was selling for) was $ 793.20. The midpoint is $ 793. Cifu said it would be typical to offer some sort of price improvement, maybe $ 792.90.

“It’s a risk-free trade,” Cifu insisted. “As soon as the price reaches us, we guarantee the broker that he will get the best price.” Cifu also noted that in recent decades the differentials of the offers have decreased, the speed of execution has improved and rates have decreased, all as a result of technological innovation.

However, many market watchers have been critical of the payment of the order flow, including Better Markets, a non-profit organization that seeks to promote the public interest in the financial markets.

In a paper distributed before the Robinhood-GameStop hearings, Better Markets stated that the payment of the order flow “is widespread and causes an inevitable conflict of interest between the obligations of the retail broker to obtain the best execution of its customers and the its obligations to shareholders and others to maximize revenue … These execution costs may outweigh the profits for retail investors associated with so-called “trade without commissions”.

Cifu says there is no data to support these claims.

“At the very least, you’ll get the same price as if you went to a stock exchange,” he said. “All brokers are on track based on improved pricing and a better execution obligation.”

A recent study by Larry Tabb and Jackson Gutenplan of Bloomberg Intelligence calls into question the idea that retail investors are disadvantaged by order flow payment: “The controversial practice of retail brokers selling customer orders to market makers (payment by order flow) benefits equity investors “by improving execution quality, with our analysis showing that Citadel Securities and its partners returned $ 3.7 billion in 2020 to investors in the form of price improvements “That’s almost three times as much as they’ve paid for this equity flow.”

Still, the idea persists that if market makers make money, they should take it from retail investors.

UBS Art Cashin, the dean of NYSE apartment traders, is also skeptical about paying for order flow: “If you’re paying for my order flow, is it to get me the best price? What’s the advantage? because the dealer will exchange there? It’s that the public is with a dealer, it’s not like the public is with an exchange. ”

Cashin offers a simple formula for determining whether the transaction is worthwhile: “Is the payment you make for the order enough to offset the free commission and offer you a price improvement? If you think it’s true, you should be comfortable. making it commission free “.

Cifu agrees with Cashin’s sentiment and again insisted that his company compete fiercely to provide the best execution. “It’s a very competitive business,” he said.

Stock exchanges have a different concern: orders from retailers heading to relatively “dark” places like brokerage brokers without interacting with stock market orders.

“The growing interest of retail investors is a welcome development,” said Michael Blaugrund, NYSE CEO.

“But all this trading in dark private places means that liquidity is becoming less accessible to institutional investors and the process of price discovery is deteriorating.”

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