“Paying for the order flow” to attract attention
With attention focused on Robinhood, GameStop and retail traders during Thursday’s Congressional hearings, deal volumes are very much the focus of attention, as is the practice of “pay for order flow”.
Talk about a comeback story.
A year ago, retail traders were a declining part of the trading world. Then Covid struck.
Millions of people stayed at home and received stimulus checks. They went online. With sports largely closed, many have turned their attention to retail stock trading for the first time.
In December 2019, retail businesses accounted for an average of 13% of total trading stock volume, according to data from Piper Sandler. By the end of December 2020, this figure had almost doubled, to 22.8%.
And these retail traders engaged in more than their fair share of the trade.
“Not only has the share of retail increased, but the volumes have grown a lot more,” said Rich Repetto, who tracks trade at Piper Sandler. Global trade in 2020 increased 55% from 2019, Repetto noted, largely thanks to retail traders.
And the trend continues into 2021. Average daily share volumes since the start of the year are 42% higher than in 2020, although Repetto noted that first quarter volumes are generally higher than the rest. of the year.
How payment for order flow works
Along with this increase in retailing has been increased scrutiny of a practice known as “payment for order flow” whereby some brokers receive payments from market makers (traders) to route orders. transactions to them.
The majority of retail trade is not done on exchanges, but by market makers who “internalize” the transactions.
Here is how it works. Suppose you want to buy 100 shares of You’re here. When you press the button of a trade, you have given your broker an order to buy 100 Tesla shares at the market price.
Your broker will usually have a prior arrangement with market makers who will compete for the order flow. The biggest market makers are Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma and UBS.
Virtu CEO Doug Cifu said his business competes fiercely for this order flow: “Most brokers have a ‘routing wheel’, and in that wheel they will send orders from clients to tenors. market based on the price improvement they provided., ”he said.
The payout rate for order flow varies from broker to broker, Cifu noted, but is generally set within the broker. A broker might charge 10 cents per 100 shares, for example. Others may charge more, others nothing.
The key point, Cifu says, is that Virtu and the other companies must meet best execution obligations, which will usually include improved pricing.
Let’s go back to this Tesla trade, to buy 100 shares. Suppose the supply (what a buyer was willing to pay) was $ 792.80, the demand (what a seller was willing to sell) 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 safe job,” Cifu insisted. “As soon as the price hits us, we guarantee the broker that they are getting the best price.” Cifu also noted that over the past decades bid-ask spreads have declined, execution speed has improved, and fees have declined, all due to technological innovation.
Is Paying for Order Flow a Good Deal for the Retail Merchant?
Yet many market watchers have criticized the payment of order flow, including Better Markets, a nonprofit that seeks to promote the public interest in financial markets.
In a document circulated ahead of the Robinhood-GameStop hearings, Better Markets asserted that order flow payment “is prevalent and causes an inevitable conflict of interest between the retail broker’s obligations to seek best execution for its clients and its obligations to shareholders and others to maximize income.… These execution costs may outweigh the benefits to retail investors associated with what is known as “commission-free trading”.
Cifu says there is no data to back up these claims.
“At a minimum, you get the same price as if you went to an exchange,” he said. “Each broker performs routing based on price improvement and a best execution obligation.”
A recent study by Larry Tabb and Jackson Gutenplan of Bloomberg Intelligence casts doubt on the idea that retail investors are disadvantaged by payment for order flow: by improving the quality of execution, our analysis showing that Citadel Securities and its peers brought investors $ 3.7 billion in 2020 in the form of improved prices, ”the study concludes. “It’s almost 3 times what they paid for this equity flow.”
Yet the idea persists that if market makers are making money, they should take it from retail investors.
Art Cashin of UBS, the dean of floor traders at the NYSE, is also skeptical about paying for order flow: “If you’re paying for my order flow, is that to get me the best price? What is the advantage? is it because the croupier is going to negotiate against him? It’s the audience meets a dealer, it’s not like the audience meets the audience with a trade. ”
Cashin offers a simple formula for determining if the transaction is worth it: “Is the payment you make for the order flow enough to offset the free commission and allow you to improve prices?” If you think this is true, you should be comfortable with it’s commission free. “
Cifu agrees with Cashin’s sentiment and once again insisted that his company competes fiercely for best execution. “It’s a very competitive company,” he said.
The exchanges have a different concern: orders from retail traders that are routed to relatively “dark” places like broker-dealers without interacting with public orders of the exchanges.
“The growing interest of retail investors is a welcome development,” said Michael Blaugrund, COO of the NYSE.
“But all of these transactions on private obscure platforms mean that liquidity is becoming less accessible for institutional investors and the price discovery process is deteriorating.”