Why US regulators should allow payment for order flow to continue

The writer is an emeritus professor at Harvard Law School and director of the Committee on Capital Markets Regulation

The new Securities and Exchange Commission chair Gary Gensler has said that one of his first acts may be to ban payment for order flow for retail trades in US equity markets. That would be a big mistake.

It would increase the cost of trading for the millions of retail investors that benefit from zero commissions and highly efficient US equity markets.

Payment for order flow is the widespread and longstanding practice whereby retail brokers, such as Charles Schwab and Robinhood, receive payments from wholesale broker-dealers, like Citadel Securities and Virtu Financial.

Wholesale broker-dealers that receive the retail orders must then seek to execute them at the best possible price, either against their own inventory of stocks or at an exchange.

Gensler asserts that the payment for order flow poses a conflict of interest for retail brokers and is increasing trading costs for investors. The former Goldman banker should know better.

The conflict of interest that Gensler posits is that retail brokers are incentivised to send customer orders to the wholesale broker-dealer that provides them with the most payment for order flow rather than the best prices for the trades of their customers.

But this is not true. Retail brokers are required by the Financial Industry Regulatory Authority to send their customer orders to wherever they can get the best price, irrespective of the payments from wholesale broker-dealers. And Finra monitors the retail brokers to make sure they are doing so.

Each retail broker discloses that it charges the same fee to all wholesale broker-dealers. So wholesale brokers do not compete with each other by paying a retail broker more for order flow.

The prices a given retail broker charges all its wholesale brokers can differ depending on the characteristics of its orders, such as their size and volume. A wholesaler broker might also pay more for orders from retail brokers in the belief their customers are less informed about the stocks they trade.

So the so-called conflict of interest for payment for order flow in practice does not exist.

However, despite this, Gensler and other critics of payment for order flow, argue that banning it could be beneficial to retail investors. They claim about $1.3bn in payments received by retail brokers annually as part of these arrangements could then be passed on to their retail customers.

But, in fact, the opposite is likely to happen. If retail brokers lost this important source of revenue due to a ban, it is more likely that they would seek to cover costs by increasing trading fees for investors, including reintroducing brokerage commissions and increasing financing charges.

Gensler is also concerned that wholesale brokers are receiving orders at all. He argues retail orders provide such brokers with information from which they can profit. But wholesale broker-dealers are prohibited from front-running the retail orders that they execute. And retail orders generally do not provide information regarding the future direction of stock prices.

There is also ample evidence that wholesale broker-dealers are performing well for retail investors and reducing the cost of trading. In 2020, wholesale brokers provided retail investors with $3.7bn in price improvement on the best publicly available prices on exchanges, according to SEC disclosures.

So even without payment for order flow, retail brokers would still be required to send customer orders to the wholesalers because they are providing retail investors with the best prices.

However, Gensler is right that there is still room for improving the functioning of US equity markets for retail investors.

The SEC should require that retail brokers provide their customers with the information necessary to compare the prices that they receive for their trades at their broker to the prices that they would have received for a similar trade at a competitor.

Such disclosures would bolster the existing obligation of retail brokers to route orders to the wholesale broker-dealer or exchange where their customers will get the best price.

The US equity markets are the most efficient in the world for investors, with significantly lower transaction costs than other highly liquid markets. Banning payment for order flow would be tantamount to throwing a wrench into a well-oiled machine. Leave well enough alone.

John Gulliver contributed to this article