Banning Payment for Order Flow Would Be a Huge Mistake

(Bloomberg Opinion) -- Payment for order flow is an indispensable tool in the democratization of markets. Coupled with the ability to buy and sell fractional shares of companies, the practice has made stock investing available to everyone. But it’s under assault, undeservedly so, and needs support. 

For those unfamiliar, payment for order flow is the reason trading apps such as Robinhood Markets Inc. and discount brokers like Charles Schwab Corp. can charge zero commissions for trades on stocks and exchange-traded funds. When an investor buys or sells a stock or ETF, the broker typically sends the order to a market maker such as Citadel Securities to execute the trade. In exchange for that order flow, the market maker kicks back a portion of its fee to the broker, thus eliminating the need for the broker to charge a commission.

The fee comes from the bid-ask spread, or the difference between what it costs to buy (ask) and sell (bid) a stock or ETF. The spread can be as little as a penny a share or more than a dollar depending on various factors, such as trading volume and volatility. During the second quarter, market makers kept about half the spread of the average retail stock trade and returned slightly more than a tenth to brokers, according to numbers compiled by Bloomberg Intelligence. The rest went to investors as price improvement, meaning that market makers executed the trades at better prices than those quoted on exchanges. 

To appreciate the significance of payment for order flow, it helps to know a bit about the history of trading commissions. For more than 180 years, from 1792 to 1975, commissions were fixed and non-negotiable. Brokers were not permitted to offer lower commissions to customers and could be barred for doing so. Investors paid anywhere from tens to hundreds of dollars a trade, and they were the lucky ones because few people had access to brokers in those days. Investing was the province of fancy Wall Street firms and the well-heeled investors they invited to play. 

On May 1, 1975, a day known as May Day, the Securities and Exchange Commission broke up the club. From that day forward, brokers could offer lower commissions, opening the door to discount brokers such as Schwab and giving millions of new investors access to markets. But not everyone. Commissions still weren’t cheap, and fractional shares were not yet an option, so buying a basket of stocks required at least several thousand dollars. Payment for order flow and fractional shares have removed those remaining barriers. Even a handful of dollars can now become a stock portfolio. 

It’s not just better for the little guy. Investors pay a spread with or without a commission, so removing commissions reduces trading costs for everyone. That wouldn’t be true if payment for order flow somehow caused spreads to widen. It just so happens that spreads have widened modestly since discount brokers eliminated commissions in October 2019. The median spread for the largest 3,000 U.S. stocks by market value was 4 cents a share at the end of September 2019. Today it’s closer to 7 cents a share.

But it would be premature to blame those wider spreads on payment for order flow or even to worry that spreads have widened for good. For one, most of the past two years have coincided with a global pandemic that has cranked up market volatility, and spreads widen as volatility increases. When the pandemic eases, spreads are likely to tighten again. Two, it isn’t the quoted spread that counts but what investors pay. Even if spreads prove to be persistently wider in the era of zero commissions, market makers may still be able to offset wider spreads with better trade execution, as they appear to have done to some extent in the second quarter. And three, giving millions of new investors access to markets may increase trading volume, which should narrow spreads over time.

It’s also worth considering that payment for order flow is a fairer system. Commissions for retail investors were mostly fixed dollars, which resulted in higher trading costs for smaller investors relative to the size of their portfolio. With commissions gone, investors big and small should bear roughly the same trading costs as a percentage of their investments, even though larger investors may still pay slightly less given that bigger trades offer more avenues to negotiate prices.

So what’s not to like? Critics say brokers have a conflict of interest because their incentive is to route order flow to market makers that kick back the highest fees, not necessarily those that deliver the best prices for investors. (Gary Gensler, the chair of the SEC, says a ban on the practice is “on the table.”) While the conflict is undeniable, brokers also have a legal obligation to obtain the best possible trade execution and to review the quality of their execution at least quarterly. They should be required to disclose the results of those reviews to investors, along with numbers showing how spreads are divided among market makers, the broker and investors. With that information, consumers can decide which brokers best manage their conflicts.

Some critics also fear that payment for order flow allows market makers to front run. They might use order flow information to place trades with their own money ahead of those of customers, thereby raising trading costs in a way that’s difficult for investors to track. But that risk exists no matter who has order flow information, which is one reason it’s illegal and within regulators’ power to monitor and enforce.

This isn’t the first time a change in trading commissions provoked a backlash. May Day was wildly unpopular on Wall Street. The New York Stock Exchange threatened to sue the SEC if it did away with fixed commissions. Responding to critics, SEC Chair Ray Garrett Jr. said this at the time: “I am hopeful that it may also be a beginning — the beginning of a new period in the securities industry based on economic reality, modern equipment and business efficiency, as well as continuing in the tradition of service to the public and effective cooperative regulation that we have seen in the past.”

And so it was. Those words are just as relevant today about payment for order flow, a logical next step on the road to more open and fair markets. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

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