What Gary Gensler Really Meant With His Order Flow Remarks

(Bloomberg Opinion) -- Market participants may have misinterpreted comments by U.S. Securities and Exchange Commission Chair Gary Gensler about payment for order flow. Gensler told Barron’s that a ban on that practice is “on the table” because it generates “an inherent conflict of interest.” Shares of Robinhood Markets Inc., Charles Schwab Corp. and other brokerages most dependent on payment for order flow promptly dropped. But Gensler’s next sentences changed his meaning significantly, and Robinhood may not be the firm most at risk.

In payment for order flow, a retail broker sends customer orders to a market maker such as Citadel Securities or Virtu Financial Inc. These firms match buy and sell orders at prices within the quoted market spreads. So if a stock is bid at $49.95 and offered at $50.05, the market maker might fill a sell order at $49.97, a buy order at $50.03 and make a profit of six cents. (These are hypothetical numbers.) Both the retail buyer and retail seller get better prices than market orders sent to an exchange. The market maker then sends payment, say two cents per share, to the retail broker. This allows retail brokers to charge zero commissions.

The conflict of interest that worries most people is the retail broker has an incentive to route orders to the market makers that pay the most, rather than the market makers that give the best prices to the end retail investors. In the example above, another market maker might fill the sell order at $49.96, the buy order at $50.04, but send 3 cents to the retail broker. The SEC already has rules to force retail brokers to get the “best execution” for customers, but there’s wiggle room in those rules.

But Gensler wasn’t talking about that conflict. He followed up with, “They get the data, they get the first look, they get to match buyers and sellers out of that order flow. That may not be the most efficient markets for the 2020s.”

Gensler is taking aim at “they,” the market makers, not at Robinhood and other retail brokers. The conflict of interest is that market makers have an incentive to keep their order flow information private. They can use it to adjust their bid and ask prices on exchanges plus dark pools and other electronic matching networks, and to take proprietary positions on their own balance sheets. In effect, market makers are bribing retail customers with good execution prices in order to keep the information content of their trading out of public view. The victims are not retail traders, but institutional market participants who are now trading at an informational disadvantage.

This is a 180-degree turn from the traditional view. The usual reason given for why market makers are willing to pay for order flow is that retail orders provide no valuable information. Buys and sells reflect personal financial situations or whims, not hard information about either fundamental values or shifts in institutional sentiment. But a market maker needs to charge a hedge fund a large spread because the hedge fund’s order carries a lot of information; if the hedge fund is buying the price is more likely to go up than down, if the hedge fund is selling the price is more likely to go down than up. The market maker, though, can afford to charge retail investors a smaller spread, because retail investors are assumed to know nothing that the market maker doesn’t already know.

That view has been challenged by meme stocks driven by retail investor interest. A first look at developing trends among retail bettors might be very valuable -- more valuable than even a peek at hedge fund trading. If that information were broadcast in public, with orders and trades done through “lit” exchanges (that is, exchanges that expose orders to the public, not dark pools), the markets might be more efficient for everyone. In particular, it might help moderate the extreme volatility around meme stocks.

And it’s not just meme stocks. A revisionist idea is developing that aggregated analysis of retail trading reveals useful information. One individual’s trade via Robinhood might not tell you as much as an order from a top hedge fund, but a million individual actions might tell you more. In any event, it’s in the SEC’s DNA to address problems with more disclosure and to order more sunlight.

If Gensler’s aim is to improve market transparency for the general benefit of all participants, rather than to make stock trading cheaper for people he probably thinks shouldn’t be trading anyway, it may be the Citadels and Virtu’s of the world whose businesses will have to change. The major lit exchanges could be the big winners.

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

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

©2021 Bloomberg L.P.