Individual investors banded together on the subreddit thread r/wallstreetbets and egged each other on to buy shares in the company GameStop. Why? To “squeeze” a number of institutional investors who had shorted the stock, or bet on its price decreasing, by pushing its price higher with their purchase of the stock and hopefully making a dime while they were at it.
As they brought the shares of the stock “to the moon” with their “diamond hands” — at its height in late January 2021 the price of a share was nearly 500 dollars, in comparison to $17.25 at the start of January 2021 and its current trading price of around $20 — the world and more importantly, financial regulators sat up and took notice.
As the price of shares in GameStop and other “meme stocks” like AMC, an American movie theatre chain, saw much volatility, regulators grew concerned. The house financial services committee in the House of Representatives called for a hearing and the attorney generals of Texas and New York announced that they would look into the matter.
The Securities and Exchanges Commission (SEC), the primary regulator of the stock market in the US, also announced that it was reviewing the incident and months later, in October 2021, released a report about the saga.
Among the factors that contributed to what happened with meme stocks, the SEC said, was the turning of securities trading into a game by trading platforms like Robinhood. This, they said, was due to the perverse interest of trading platforms to encourage trading activity by users to increase revenue for themselves — through the controversial practice of Payment for Order Flows.
Thus, it is no surprise that the practice of payment for order flows might soon face disruption from the SEC.
Almost two years after everyday joes disrupted the financial markets through the power of social media, in December 2022 the commission voted in favour of advancing significant changes to the American stock market rules that, while falling short of banning payment for order flows, will impose additional requirements on the practice if implemented.
The SEC is currently seeking feedback from the public about the proposed changes before the agency decides whether to enact them.
Confused about what’s going on? Fret not. This article will explain what exactly the practice of payment for order flow is, why it is controversial and look into how the proposed regulation might potentially affect trading platforms and retail investors.
Payment for What?
To understand the practice of payment for order flows, we first need to understand the mechanics of how the click of a button on our desktops, or increasingly on our phones, results in the buying or selling of shares.
While it might not seem or feel this way, we are not directly buying or selling a share from a stock exchange or the securities markets when we trade on a brokerage platform like Fidelity or Ameritrade.
Instead, when you push a button, or if you are old-fashioned and call your broker to place an order, the broker receives the order from you and is now tasked with executing it on your behalf.
To execute your order to buy or sell a security, one option the broker has is to channel the order to a stock exchange like the New York Stock Exchange (NYSE) or closer to home, the SGX. If directed to a stock exchange, the trade is executed in line with the procedures of the exchange. The NYSE, for instance, is an auction market where bids and asks for the entire market is posted for the entire market to see and the players in the market can then “compete” with each other to competitively fill the order — thereby giving the investor the best price on the trade.
The other option brokers have is to send the order to a market maker. The market maker is essentially a firm, or occasionally an individual, that maintains an inventory of particular shares and from that inventory, fills the orders that brokers send to them, making a profit from the spread — the divergence in price between the bid and ask.
So for instance, if the current bid and ask price for fictional stock A listed on the NYSE is $1.00 and $1.05 — a broker can either direct an order they receive to the NYSE and allow market participants to bid on the order, or alternatively, they can send the order to a market maker who might buy the share for $1.01, sell the same share to another broker for $1.04, and pocket the difference of 3 cents.
For a market maker, having a large trading volume is important for two reasons. Firstly, having more trades to execute simply means more opportunities for them to “capture the spread” and therefore earn more profits for themself. But secondly, liquidity — the ease at which a broker can buy and sell a security with them — is also a key consideration for market makers. The more trades brokers send to them, the more “liquid” they are.
For these two reasons, market makers have an incentive to have a large volume of orders from as many brokers as possible sent to them. But how does a market maker get a broker to send them the orders they receive? By paying them to do so, of course.
Thus, market makers pay brokers to send their orders over to them, instead of other market makers or stock exchanges. Or, in other words, payment for order flow!
The Good, the Bad and the Ugly
One argument made for clamping down or outright banning the practice of payment for order flows is that there is a conflict of interest on the part of the broker. While you ideally want your broker to do what he/she can to get you the best possible price on your trade, the fact that the broker receives money from market makers to channel your order to them means that the broker has less of an incentive to get you the best price on a trade.
Another argument that has become more salient lately is the way payment for order flow pushes trading platforms and brokers to encourage more trading activity from retail traders, even if it may be against their interest. While a conventional broker receives a commission or a fee from retail investors to execute their trades for them, while perhaps also receiving more money from market makers to send them order flows, there has been a new crop of trading platforms like Robin Hood that charge zero commission from their customers to execute their trades for them. Instead, they rely more heavily on payment for order flows, even when they do have other sources of revenue.
When competitors offer zero or low commissions, other firms may feel like they also have to slash their commissions and rely more heavily on payment for order flows to attract customers.
Because of the fact that they make more money when they funnel more orders to market makers, these firms have an incentive to get investors to trade more actively on their platforms. They do so by “gamifying” the act of trading securities by, for instance, displaying confetti animation when a user makes their first trade — not unlike what is displayed to players who unlock a new level in a computer game.
This is problematic firstly because even if traders are paying no commissions on their trades, they are still buying and selling securities with their real money, money that they can potentially lose. The gamifying of the act of trading securities might obscure this reality. Secondly, the conventional wisdom is that a good strategy for retail investors to generate wealth is to buy and hold securities with solid fundamentals over the long term, not by getting in and out of stocks rapidly — which firms like Robinhood have an incentive to encourage.
On the flip side, there are two arguments often made in defence of the practice of payment for order flows.
The first argument is that retail investors actually do benefit from market makers filling their orders instead of stock exchanges. Market makers do often offer better prices for trades than exchanges and thus, individuals benefit from their orders being routed to market makers.
The issue with this claim is that this is an argument for the existence of market makers and not one that defends the specific practice of payment for order flows. One might even argue that in a world without payment for order flows, market makers are forced to compete with one another for orders from a broker solely on the basis of fundamentals like the price of trades and execution quality.
The second argument is that when brokers rely on payment for order flows, they are able to offer commission-free trading or at least lower commissions to retail investors. This is the main line of attack being pushed by firms like Robinhood in light of the proposed SEC regulations.
“If you think about the ramifications of these proposals, you’re essentially shutting the door and saying we liked it better when it was the old boys’ club,” Robinhood Chief Brokerage Officer Steve Quirk said in an interview to The Wall Street Journal this month in response to the proposed regulations.
However, as payment for order flow practices have come under both heightened scrutiny and greater criticism, companies like Robinhood have already tried to diversify their revenue streams. Some analysts also dismiss the view that the proposal will revive commissions as self-serving and alarmist, arguing that those seeking to charge for traders will face competition from firms that can offer zero commission without a heavy reliance on payment for order flows.
A Fine Line
On one hand, insufficient oversight puts retail investors, who often have little power in the markets and are at the short end of an information asymmetry, at risk of being taken advantage of or losing much of their hard-earned money.
Yet, on the other hand, excessive regulation risks securities tradings once again made inaccessible to the average Joe or the plain Jane.
The challenge for regulators will be to strike a fine balance between these two competing interests — to ensure that retail investors are able to continue to access the markets without too much difficulty while also being sufficiently protected when they do so.