‘Order flow payment’ to attract attention

With attention focused on Thursday’s congressional hearings on Robinhood, GameStop and retailers, trading volumes are very much in focus, as is the use of ‘order flow payment’.

Talk about a comeback story.

A year ago, retailers were a declining part of the trading world. Then Covid struck.

Millions stayed home and received stimulus checks. They went online. While sports were largely closed, many people were looking at retail stocks for the first time.

According to data from Piper Sandler, in December 2019, retail industries averaged 13% of total trading volume. By the end of December 2020, it had almost doubled to 22.8%.

And the retailers have done more than just their fair share of the trade.

“Not only did retail’s share in the trade rise, but it also fell much higher,” says Rich Repetto, who follows the trade in Piper Sandler. Total trading in 2020 has increased by 55% from 2019, Repetto noted, much of it driven by retailers.

And the trend continues until 2021. Average daily stock volumes to date are 42% higher than 2020, although Repetto noted that volumes in the first quarter are usually higher than the rest of the year.

The increase in retail has led to a larger investigation into a practice known as ‘order flow payment’, whereby some brokers receive payments from market makers (traders) for forwarding transactions to them.

The majority of retail is not done on exchanges, it is done by market makers who “internalize” the trades.

Here’s how it works. Suppose you want to buy 100 shares of Tesla. When you press the button for a transaction, your broker has instructed you to buy 100 shares of Tesla at the market price.

Your broker usually has a predetermined agreement with market makers that will compete for the order flow. The larger market makers are Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma and UBS.

Doug Cifu, CEO of Virtu, said that his firm competes fiercely for the order flow: ‘Most brokers have a’ steering wheel ‘and within the wheel they will send client orders to the market makers based on the amount of price improvement they have provided. . , “he said.

The payment rate for order flow varies from broker to broker, Cifu noted, but is usually set within the broker. For example, a broker may charge 10 cents per 100 shares. Others may ask for more, some nothing.

The most important point, according to Cifu, is that Virtu and the other companies must meet the best execution obligations, which will usually include price improvement.

Let’s go back to the Tesla trade to buy 100 shares. Suppose the bid (for which a buyer was willing to pay) was $ 792.80, the demand (for which a seller was willing to sell) was $ 793.20. The centerpiece is $ 793. Cifu said it would be typical to offer some sort of price improvement, perhaps $ 792.90.

“This is a risk-free trade,” Cifu maintained. “As soon as the price hits us, we guarantee the broker that they will get the best price.” Cifu also noted that bid-ask spreads have declined over the past few decades, improved export speeds and that fees have dropped, all due to technological innovation.

Yet many market observers have been critical of the payment of order flows, including Better Markets, a non-profit organization that seeks to promote public interest in the financial markets.

In an article circulated prior to the Robinhood-GameStop hearings, Better Markets claims that order flow payments are widespread and cause an inevitable conflict of interest between the retail broker’s duties to best perform its customers and its duties to shareholders. search. and others to maximize revenue … These execution costs may outweigh the benefits to retail investors associated with the so-called ‘commission-free trade’. “

Cifu says there is no data to support these allegations.

“You get at least the same price you would get if you went to a scholarship,” he said. “Every broker is on the road to price improvement and a best execution commitment.”

A recent study by Bloomberg Intelligence’s Larry Tabb and Jackson Gutenplan casts doubt on the idea that retail investors are disadvantaged by order flow payments: “Retail brokers’ controversial practice of selling client orders to market makers (order flow payments) benefits investors in equities. “, with our analysis showing that Citadel Securities and its peers returned $ 3.7 billion to investors in 2020 in the form of price improvements,” the study concluded. “That’s almost three times what they paid for that stock flow.”

The idea still persists that if market makers make money, they should take it from retail investors.

UBS’s Art Cashin, dean of floor traders at the NYSE, is also skeptical about paying the order flow: “If you pay my order flow, then is it to give me the best price? What’s the benefit? Is it because the trader “It’s the public that meets a trader, it’s not as if the public meets the public with a stock exchange.”

Cashin offers a simple formula to determine if the transaction is worthwhile: “Is the payment you make for an order enough to reimburse the free commission and give you a price improvement? If you believe this to be true, you should feel comfortable doing it commission free. ‘

Cifu agrees with Cashin’s sentiment and has again insisted that his firm compete fiercely to deliver the best execution. “It’s a very competitive business,” he said.

The exchanges are otherwise concerned: retail orders sent to relatively ‘dark’ places, such as brokerage dealers, without communicating with public orders of the exchange.

“The growing interest in retail investors is a welcome development,” said Michael Blaugrund, chief operating officer of the NYSE.

“But all this trading in private, dark windows means that liquidity is becoming less accessible to institutional investors and that the price development process is deteriorating.”

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