Payment for order flow (PFOF) is under the microscope again, but this could be the tip of the iceberg.
In the wake of the surge in retail trading and the meme-stock trading frenzy during the first quarter of this year, the Securities and Exchange Commission (SEC) is conducting an analysis of retail order routing through wholesale market-makers and the innerworkings of U.S. equity market structure.
In an Aug. 30 interview with Barron’s, SEC Chairman Gary Gensler made headlines when he said that a full ban on payment for order flow is “on the table,” suggesting that it creates an inherent conflict-of-interest for retail brokers with best execution, if they were to focus on routing to where they earn the most profits, rather than the best price for their customer’s execution.
An SEC report is expected to come out by the tail end of the year, according to Bloomberg Intelligence analysts on a recent briefing. But, while the report was initially about the meme-stock trading episode in January and the role that social media and gamification of mobile apps may have played, the SEC’s inquiry has morphed into a broader review of related-equity market structure issues.
Speaking at the SIFMA Equity Market Structure Webinar: A Mid-Year Review, David Shillman, an Associate Director in the SEC’s Division of Trading & Markets, said a number of issues – segmentation of retail order flow, PFOF, concentration of wholesale market makers, and best execution “were revealed” by the January meme-stock trading episode. He also noted that Chairman Gensler has “asked the staff to look a broader set of issues — Reg NMS more generally, minimum pricing increments, off-exchange trading, and rebates.”
While the SEC has a lot on its plate, “the heart of the debate” seems to be around payment for order flow, said Nathan Dean, Senior Analyst – U.S. and LatAm Policy at Bloomberg Intelligence on the briefing.
Depending on the report’s recommendations, this could lead to far-reaching changes in equity market structure such as proposing rules to push retail flow back to public exchanges. If PFOF is potentially curtailed or prohibited, it could impact retail investors that have benefited from commission-free trading as well as the wholesale market-maker model of matching retail orders to buy and sell stocks out of inventory, a process known as internalization.
With PFOF, online brokerages such as Charles Schwab, TD Ameritrade, Robinhood receive a fraction-of-a penny payment in exchange for sending orders to wholesale brokers such as Citadel Securities, Virtu Financial or Two Sigma for execution at the best publicly available price displayed across all U.S. exchanges based on the National Best Bid and Offer (NBBO).
Debate over PFOF flared up after the January events put a spotlight on the handling of retail orders and the increase in off-exchange trading. In a June 9 speech at the Global Exchange and FinTech Conference, Gensler raised concerns that only 53% of volume was executed on public exchanges in January, noting that about 47% of trading interest was not displayed on lit markets. Of the 47%, about 38% was traded largely through seven wholesalers, and the remaining 9% was traded on alternative trading systems or dark pools, said Gensler in his prepared remarks. With such a significant portion of retail orders being priced away from the lit markets, Gensler also said, “there are signs that the NBBO is not a complete enough representation of the market.”
Another issue is that institutional investors and professional traders cannot interact with retail order flow internalized by wholesalers. Wholesale broker-dealers execute approximately 70% of the markets orders they receive out of their inventory of stocks and route the balance to other market centers, according to report by the Committee on Capital Markets Regulation. Limit orders, which must be executed at price that is no worse than the limit price set by the customer, are generally displayed and typically executed on exchanges, it said.
In terms of the industry conversation around PFOF, “there are two schools of thought,” said Sapna Patel, Head of Market Structure and Liquidity Strategy at Morgan Stanley on the SIFMA panel. “Either people believe that it leads to conflicts-of-interest in broker-dealers carrying out best execution, or PFOF has made the experience for retail cheaper or better to trade in the market due to zero commissions coupled with the price improvement they get,” said Patel.
According to Rule 605 disclosures by wholesale broker-dealers, retail investors collectively received $3.7 billion in price improvement in 2020.
Robinhood Maximized PFOF
If the SEC were to curtail PFOF, it could impact retail brokerages such as Robinhood that rely heavily on it. For 2020, payment for order flow was over 71% of Robinhood’s total revenues, and then it decreased to roughly 63.5% for the first quarter of 2021, according to data from Bloomberg Intelligence.
“Clearly their revenue is very significantly based on transactions in trading,” said Larry Tabb, Head of Market Structure Research at Bloomberg Intelligence on a July 19 virtual event “The Rich and Poor of Robinhood’s Coming IPO,” which examined the impact of PFOF and regulatory risk on Robinhood’s business.
The trading profits that wholesalers generate, get split three ways, said Tabb. A portion is captured by the wholesaler, then it gets split into PFOF for the broker, and then the broker decides how much is shared with the investor as price improvement. “Robinhood has dialed that PFOF process much more toward the broker than the client,” he said, noting that there is variability among brokers in how they divide up the payments.
Robinhood was fined and agreed to pay $65 million by the SEC in December for not disclosing the “receipt of payments from trading firms for routing customer orders and with failing to satisfy the best available terms to execute customer orders,” reported CNN.
But, PFOF revenues have fluctuated with market volumes as well as numbers of new retail customers. “PFOF peaked in January along with OTC shares that were traded. It may really remain under pressure if it continues to follow market volume,” said Tabb in mid-July.
In the second quarter, PFOF revenues declined 29.8% from Q1, according to Tabb’s Twitter post on Aug. 18. “Robinhood was the largest recipient, but by less margin than 1Q,” wrote Tabb.
Despite the criticism waged at PFOF, many brokers, traders, and academics maintain that retail investors are getting better prices from market makers than if their orders were routed to exchanges. “When retail orders are bought by wholesalers, they can price improve those orders, pay them better prices than they get from exchanges because they can validate the flow is from retail investors,” said Tabb.
“By segmenting these flows, they know it’s not a hedge fund actively buying a company’s shares or an institution buying a million shares who is going to push up the price higher,” he explained. By contrast, exchanges offer “open access” to all investors, so market makers posting limit orders on exchanges are less willing to offer tighter spreads out of fear of getting run over by an institution, said Tabb.
Citing data from 605 reports, Tabb maintains that PFOF benefits retail investors in terms of execution quality. “If you are an individual investor, you are getting a quarter to a third of the spread back in terms of price improvement,” said Tabb, who added, “It turns out to be a fair amount of money.”
Based on looking at E/Q Q2 statistics from 605 reports, on average market makers captured 48.5% of half-the-penny spread, retail investors received 38.2% in price improvement, while the broker kept 13.3% of the spread as PFOF. “Of half the spread, the investor gets the lion’s share – more than a third,” said Tabb. On average, retail orders were executed at prices better than the NBBO by 0.489 cents a share, which is 38.2% of the 2Q average bid/offer spread, wrote Tabb in a research report “Order-Flow Payments Ban, Status Quo or Improve Markets for All.”
However, a research report by BestEx Research CEO Hitesh Mittal estimates that spreads would tighten by 25% or more if retail order flow were to move back to public exchanges. The report, “The Good, the Bad, the Ugly of Payment for Order Flow,” asserts that “price improvement statistics touted by wholesalers and retail brokers is overestimated because they do not account for hidden orders and odd lots of liquidity inside the [National Best Bid and Offer] NBBO.”
Challenges to Banning PFOF
Implementing a ban on PFOF is going to be challenging, according to Tabb, shedding light on some of the inherent complexity. “The flow could shift to exchanges which pay rebates – which is another type of incentive. But the rebates don’t necessarily go back to investors, and rebates are not available on every transaction,” he said.
In addition, many retail brokers don’t accept PFOF, but they still route orders to wholesalers to execute which is known as internalization. “So that flow won’t make it back exchanges anyway even if you ban it,” he said.
Given that retail flow is valuable, Tabb predicted wholesalers would create other types of service channels, such as software-based service bureaus to replicate the economics, so other payment mechanics could develop.
While regulators could seek to ban PFOF, that could involve making changes to the Securities Act of 1934, requiring Congress’s support, said Tabb. This could be hard to get since New York’s Senator Charles Schumer heads the senate and has close ties to the financial community, he noted.
As an alternative, retail brokers could set up their own internal trading desks, but that would create other conflicts, he said. “How good could an inhouse broker be at earning best execution?” asked Tabb, noting they would be in competition with the sophisticated wholesalers.
But PFOF has allowed retail brokers to offer zero-commission trading, which has resulted in more investors gaining access to the stock market. If the SEC decides to ban PFOF, then brokers will need to revert to charging commissions, suggested Tabb.
Even if PFOF were eliminated, there are always going to be economic incentives around order routing, cautioned Morgan Stanley’s Patel, pointing to a conversation the industry had three years ago about banning exchange rebates for a transaction-fee pilot. For example, brokers or exchanges can charge lower access fees, or offer cheaper market data or port costs to incentivize order flow. What matters “is how broker-dealers provide best execution knowing that economic incentives are not going away,” said Patel.
Rather than banning PFOF, Tabb pointed to “less obtrusive ways” to fix the equity market structure without hurting retail investors. Among the remedies he suggested are putting odd lots on broker’s 605 reports so that investors have more detail on execution quality. Regulators could also put odd lots on the tape, which might reduce bid-offer spreads, he said. Another avenue is to improve the “time granularity” on the 605 report time buckets, with the most timely currently at 1-9 seconds, given that orders are executed in milliseconds. “Shortening these time buckets would lead to better transparency and put greater price improvement pressure on wholesalers,” he said.
The SEC could also mandate better reporting of price improvement. Right now, disclosure of price improvement is only required of the wholesaler, not the retail broker, said Tabb.
Reducing the tick size on U.S. stocks from a penny to sub-penny increments is another change supported by wholesalers and other market participants to make exchanges more competitive against wholesale market makers and dark pools that can quote in sub-pennies. Right now, the U.S. minimum tick size is mandated at a penny. “One cent is too wide for lower-priced high-volume stocks; one cent is too narrow for higher-priced stocks,” said Tabb.
What’s likely to happen is that the SEC will conduct an analysis of PFOF for the rest of the year, said Nathan Dean of Bloomberg Intelligence on the briefing. At that point, the SEC typically puts out a proposal or one with incremental changes with a 60-to-90-day comment period and then a finalization of a final rule, said Dean. Assuming the report is published late this year, a proposal could come out early next year, which could mean that changes are not made until 2023 or even 2024 or thereafter.
If the SEC follows the proposal route, the regulator “will give the industry plenty of time to react and plenty of steps along the path to comment and potentially change the path of where it’s headed,” he said.
Where is this review headed?
Although PFOF is under regulatory scrutiny, analysts at Bloomberg Intelligence said their belief is that banning PFOF is not going to happen. Citing the positives delivered to the retail investor, “that’s going to be an argument hard politically to get over,” said Dean. “Disclosure, transparency, and reporting are likely the items that are in store here,” said Dean. Going further, the SEC could clarify the rules on best execution for broker dealers, and they could print the amount of PFOF received on the trade confirm, as Tabb recently suggested.
On the other hand, Chairman Gensler is known for taking on tough issues. When he was chairman of the CFTC, he was instrumental in implementing new derivatives rules under the Dodd Frank Act which pushed swaps to trade on swap execution facilities (SEFs) despite opposition from Wall Street. It remains to be seen how far the SEC will go, but clearly a lot is on the table.