Why disallowing payment for order flow is easier said than done

Is it possible to disallow payment for order flow without disallowing payment for order flow?

That’s the question raised by a series of stock market rule changes outlined this week by Securities and Exchange Commission Chairman Gary Gensler. None of them is a simple payment ban for order flow – or PFOF – which is the highly controversial practice of retail brokers like Robinhood Markets or Charles Schwab of sending client orders to trading firms. market makers such as Citadel Securities or Virtu Financial and to collect payments from these firms in return.

But the ideas could still potentially add up to an overhaul of how retail brokerage works.

What Gensler presented this week were his opinions which he asked SEC staff to consider in any possible rulemaking proposals, and so it may be years before they become complete rules.

But the market already appears to be predicting a significant impact on brokerage stock earnings. Since June 6, when some of the proposals were announced, shares of Charles Schwab have fallen about 4%, roughly the expected earnings per share for 2023 attributable to the flow of stock orders, according to the report. Wolfe Research analyst Steven Chubak.

Robinhood is down about 11%, slightly more than the 9% average revenue per user expected in 2023 that would come from PFOF stock, according to Wolfe.

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Not all of the proposals would necessarily upset the status quo for brokers, which is to charge no commission but earn revenue from processing customer orders, including through PFOF. For example, Robinhood has backed at least one of Gensler’s ideas in the past, which allows prices to be quoted and traded below a penny in the market.

But among Gensler’s broader concerns are what he says are conflicts of interest between brokers looking to earn the most on an order and clients looking for the best price. He suggested that order-by-order auctions could be used for retail stock orders. Auctions could certainly change the way things work, albeit in complex ways.

In some theoretical scenarios, having market participants compete for the best price improvement could eliminate the possibility of also paying the broker for the order. However, much of this will likely depend on how the auctions are structured, who participates in them, and whether the prices or fee changes that come with them.

Wholesalers might not bid on certain orders that would be sent to them today to improve prices; what happens to these? The options market has retail auctions, but payment order flow is still present. Gensler said the SEC should seek to learn from the options market.

Brokers have ways beyond the PFOF to earn revenue on commission-free trades. As Gensler pointed out, some brokers do not accept PFOF but still offer free trades. Some of these brokers may do things like internalize orders, which may involve matching bids and offers from clients and earning the spread between them.

But it’s unclear how this could match a bidding requirement. Brokers can also make money by sending orders to exchanges that pay rebates, but that’s also a practice Gensler asked staff to consider how to mitigate conflicts they see. He also proposed transparency measures such as letting investors know how much a broker has to pay to access a listing on an exchange.

Ultimately, brokerage revenue has to come from somewhere, even if free trade is a kind of loss leader for other revenue streams. Brokers might start passing on more regulatory fees or charging new fees to heavy users, or seek to earn more from customers’ money by paying minimal interest. Investors who have made offers on brokerage stocks should consider the full picture.

Write to Telis Demos at [email protected]

This article was published by The Wall Street Journal, part of the Dow Jones


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