Gensler Swims Against Tide in Payment-for-Order-Flow Fight

(Bloomberg) -- Banning payment for order flow is “on the table” at the U.S. Securities and Exchange Commission, but pulling it off won’t be fast or easy for Chair Gary Gensler.

The SEC chief rattled Wall Street this week when he hinted in an interview with Barron’s that he may be willing to prohibit brokers from getting paid to send customers’ stock orders to trading firms. The practice is deeply ingrained and has been embraced by everyone from Robinhood Markets Inc. to Charles Schwab Corp. It’s also triggered an era of free trades. 

That’s why industry analysts and lobbyists argue that the SEC will tread carefully because it’s loath to take any action that could increase costs for retail investors. And there are questions about whether it would even be legal for the agency to issue a ban. Instead, most firms say they expect the regulator, after months of debate and rulemaking, to require brokers to better disclose how they profit from the arrangement. 

If Gensler does pursue harsher measures, they would likely take years to implement -- meaning brokers probably won’t have to revamp their business models anytime soon. 

“This process will likely take longer than some investor advocates had thought and hoped,” Capital Alpha Partners policy analyst Ian Katz said in a research note Tuesday. “The lapse of time invariably helps the opponents. It gives them more time to chip away at Gensler’s arguments.”

In the Monday Barron’s interview, Gensler said payment for order flow has “an inherent conflict of interest” and that eliminating it was “on the table.” While Gensler has made similar comments before, shares of Robinhood tumbled -- in part because about 80% of its second-quarter revenue came from payments it received for clients’ stock, options and cryptocurrency transactions.

Congressional Action

Democratic lawmakers have also said the payments should be banned. In July, the House Financial Services Committee passed a bill that directed the SEC to study the issue and “consider banning or limiting” the arrangement but it didn’t go as far as calling for a prohibition. The measure, however, faces steep odds in a 50-50 Senate.

“The conflicts of interest and harms to investors and markets are clear, but the politics are a lot murkier,” said Tyler Gellasch, executive director of the Healthy Markets Association trade group whose members include large asset managers. “The current conflicted system has beneficiaries with deep pockets, skilled lawyers, and significant political influence.”

Payment for order flow has been around since at least the 1980s, and its backers say the practice has dramatically reduced trading costs. Years after Robinhood began offering commission-free trades, most major online brokerages followed suit in 2019. Citadel Securities is among market makers that dominate the business of paying brokers for orders and executing transactions. 

A representative for Citadel Securities declined to comment. SEC spokespeople did not immediately respond to requests for comment. 

Some jurisdictions, including the U.K., have already banned payment for order flow. The CFA Institute said the U.K.’s decision was a positive development: the proportion of retail-size trades that got the best quoted prices rose to 90%, up from about 65%, between 2010 and 2014, the organization wrote in a 2016 report. 

Online brokers argue that replacing customer-paid commissions with revenue that comes from market makers has opened up investing to millions of young people, including women and minorities who traditionally have kept their money out of the securities markets. Firms also argue that the vast majority of the retail orders they offload are executed at a lower price. That complies with SEC rules that demand investors get the “best execution” for trades.

‘Inherently Corrupt’

Opponents, however, say the order payments are difficult to understand and include hidden costs that investors pay without even knowing. They also give the massive trading firms knowledge of where the market is heading, an advantage critics say Citadel Securities and others exploit to line their own pockets.

The practice is “inherently corrupt; it’s payola,” said John Britt, a retired SEC enforcement lawyer in Los Angeles, who supports banning the payments. He added that despite the industry’s claims, trades aren’t really free. “At the end of the day, it’s investors who are paying for it on the back end.”

Jonathan Macey, a professor at Yale Law School, says Gensler’s comments indicate the SEC leader believes he has the power to ban payment for order flow, even if the regulator’s authority to actually do so is unclear.

“I doubt he would have said it if he didn’t think he had some statutory basis,” Macey said. “I could see them requiring all types of disclosure and the like, but I’m not sure where they get the authority just to ban it.”

If that does happen, brokers are likely to sue the agency in an attempt to halt the rule. They may also be able to find alternative sources of profit, some noted. 

“If you turn off this one nozzle, retail brokers like Robinhood will probably find ways to turn on other ones,” said Daniel Aisen, Chief Executive Officer of Proof Trading, an institutional equities broker. 

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