Investors and Congress are awaiting an imminent report from Securities and Exchange Commission Chair Gary Gensler on the GameStop/Robinhood/Reddit saga, as well as his recommendations on what, if any, changes should be made in the U.S. trading system.

Gensler has told Congress that his staff has been looking into both issues and promised a report by the end of summer on the following: 

1) GameStop/Robinhood/Reddit: In January, investors in Reddit chatrooms and subreddits like WallStreetBets drove up the value of GameStop shares. Robinhood suffered from the loss of many trades.   

2) Market structure: Gensler has expressed concerns about several aspects of the U.S. trading system, specifically “gamification” of trading (trading with game-like features such as points, rewards, leaderboards, bonuses, and competitions to increase engagement). In exchange for payment, brokers like Charles Schwab can send orders to the market maker. Some brokers can charge no commissions because of this. 

Larry Tabb is the head of market structure at Bloomberg Intelligence. We asked him for his insight into order flow payment. This interview was edited for clarity, and conciseness.

Gary Gensler (SEC Chair) has stated repeatedly that he is concerned that order flow payment is an issue for markets, and that banning it “is on the table”. Are retail investors being ripped off?

There is no. The retail investor is getting the best deal they’ve ever seen. In 1980 it was $200 to enter a trade and $200 to exit. Sometimes, you didn’t even receive confirmation for the trade until a few days later. Today’s commissions are negligible. In 2019, instead of paying $4.99 for a trade, all you pay is a fee for order flow.  Execution is also much better than ever. Spread has narrowed across all markets.

Do you think payment for order flows is a problem in the general market?

Retail investors are not affected by it. Institutional investors, traders and others might find it problematic if they want to trade against the retail order flow.

They can trade against it.

Citadel, Virtu and Virtu account for the vast majority of order flows.

How about those wholesalers who dominate the market? Do you think that is a problem?

While some may say “yes”, others will disagree. It is not a major problem, according to statistics. It is possible, however that there were other companies who could have executed an individual order better. Overall, the deal seems very attractive and retail investors seem to get a great deal.

Is there a cost per order for individual investors?

The reports submitted by brokers were analyzed. For order flow, the wholesaler pays 17 cents for 100 shares. A price increase of 60c per 100 shares is possible. 

What does it mean for the retail investor

The client gets 60 cents for each hundred shares more pricing than if it were traded at the top bid and best offer. They also get free execution. The commission went from 4.99 cents, which is about average commission price for September 2019, to 17c per FOF.

Wholesalers claim that they offer price improvement. This is how it works.

What is the wholesaler doing? Price improvement is the difference between the execution they do and their bid-offer spread. Investors save money because they get a lower price than the one they were shown.

Here’s an example.

Imagine a stock having a $20 bid and a $20.10 ask. Someone is interested in buying 100 shares. 20.05. Wholesalers might produce at $20.08. A retail investor can save the two cents that are between $20.08 & $20.10. The wholesaler captures three cents — the difference between the midpoint ($20.05) and what it was sold for ($20.08). According to our research, the wholesaler would return about 0.6cs to the broker while the wholesaler would earn about 2.4cs. That 0.6 cents paid to the broker cover the cost of the trade — there is no commission. The client receives two cents more execution and a free trade.

This doesn’t seem like a terrible deal. Gensler is concerned.

Citadel and Virtu may also be concerned. 

It could be the competitors to Virtu and Citadel.

This could also be market makers outside of Virtu or Citadel who lack liquidity access. 

Gensler also stated that he would like more competition in the space. However, Citadel and Virtu say they provide price improvement and there is plenty of competition.

There are also firms such as Hudson River who have made it clear that they intend to enter the market.

Is it possible to calculate how many order flow brokers receive compensation? 

There are approximately 12 big firms. The largest ones that pay are Schwab [which is Schwab, Ameritrade, and Ameritrade Clearing], Robinhood, and E-trade [now owned by Morgan Stanley]. TradeStation and Ally get paid as well. 

However, there are many others that do not get paid.

Yes.  No.

Gensler is having a problem with the payment for order flows. It takes away trading from “lit stock exchanges.”  Why shouldn’t there be more trading on exchanges?

We should, in general. It is great to have more price discovery. However, these exchanges are currently for profit. It has become a data-based business. Many traders feel they get charged extremely high prices for their data.

Gensler claims that investors would get higher prices if too little of the order flows were available to the wider marketplace. Are his claims correct?

You can place an order at over 100 places. There are 16 exchanges and 32 dark pools. 150 broker/dealers can internalize. According to theory, prices will tighten if there is a lot of order flow on the exchanges. Is it possible for the prices to tighten beyond that 60-cent price boost given to an investor or less? If you put all of the order flow on an exchange, I think you’d get price improvement but not as great as what the retail investor gets today. It would allow institutions to transfer value instead of retail. You might get only 40cs instead of the 60 cents. The remaining 20cs could go to other traders. 

Gensler noted, too that in some countries such as Canada payment for order flow may be illegal.

Gensler is not quite right. They don’t have PFOF in Canada. However, brokers have priority for retail orders. This allows them to trade before everyone else. It’s almost like an open pool. He just needs to honor the highest price. It is not a good idea to compare our markets with others. It is more costly to trade and own stocks in the UK than it is in Australia. American capitalism is built on stock ownership in corporations. The growth of an economy is funded by individuals. Our market structure makes it easy for investors to purchase stock.

How about the subpenny rule.  Exchanges are not allowed to trade in increments of less than one penny. However, Virtu and Citadel can operate in sub-pennies.

Wholesalers have an unfair advantage because of this. Everyone should trade at the same rate, in a half-cent- or quarter-cent increments.

Gensler seems to be worried about the issue for other reasons.

This issue has been a problem for Congress since the beginning. The issue was also connected to GameStop.

Is there anything you think should be done regarding payment for order flow

First of all, they are outdated. They should be modernized. We need more disclosure. It is necessary to update reports from wholesalers about how quickly orders are fulfilled. They also don’t include odd lots [orders of less than 100 shares]. It is also important to improve pricing benchmarks for large orders. This would give investors more information to help them understand the execution of orders. There is more competition when there’s increased disclosure.

The bottom line:

American markets are very efficient. Retail investors would be hurt by the ban on PFOF, but institutions would benefit. Retail investors would be disenfranchised if we provide more information to improve the market efficiency.