Payment for Order Flow: The SEC Proposes Reforms
February 22, 2023
Payment for Order Flow: The SEC Proposes Reforms
The past few years saw an unprecedented surge in retail
Under Rule 606(a) of Regulation NMS, broker-dealers must
investor securities trading at major discount broker-dealers
provide quarterly, aggregated public disclosure of their
such as Robinhood, Charles Schwab, TD Ameritrade, and
practices in the routing and handling of “held orders,”
E*Trade. Among the driving factors are the zero trading
which require prompt execution at the best possible price.
commissions many now charge for trades. The nonexistent
Generally, upon a customer’s request, under this rule, a
commissions are often subsidized by a controversial rebate
broker-dealer must provide customer-specific disclosures
paid to the broker-dealers of fractions of a penny per share
related to the routing and execution of the customer’s
called payment for order flow (PFOF) by entities known as
exchange-listed securities submitted on a “not held” basis
market makers, internalizers, or wholesalers, such as the
that gives the broker-dealer both time and price discretion
market dominant Citadel and Virtu, which execute the
during the prior six months.
orders. The wholesalers can profit by earning the bid-ask
spread (matching buyers generally willing to pay a slightly
Under Rule 607 of Regulation NMS, broker-dealers must,
higher price to sellers generally willing to take a lower one)
upon opening a new customer’s account, provide annual
and trading against the retail orders. In the latter case, the
descriptions of the terms of any payments received for
orders represent profit-making opportunities because as a
order flow and any profit-sharing arrangements that may
group, retail investors are perceived to be less informed and
influence a broker-dealer’s order routing decision.
less sophisticated vis-à-vis institutional investors whose
trades are generally conducted on other trading venues such
The SEC’s Proposed December 2022 Reforms
as stock exchanges. Reports indicate aggregate PFOF
On December 14, 2022, six months after SEC Chair Gary
revenue for stocks was about $0.9 billion for 2022.
Gensler expressed concerns over the fairness of PFOF and
proffered an alternative protocol of order-by-order auctions,
At the center of policy debates over PFOF is the broker-
the SEC commissioners voted 3-2 to propose a new set of
dealer’s duty of best execution with respect to customer
PFOF rules for certain retail equity trades. The proposal
trades, a duty that is chiefly enforced and historically
would amend Regulation NMS by adding a new rule, Rule
defined by the Financial Industry Regulatory Authority
615, designed to help “bring greater competition in the
(FINRA), the frontline regulator of broker-dealers. Best
marketplace for retail market orders.” The rule was one of
execution denotes the broker-dealer’s obligation to seek the
four market structure proposals concurrently adopted by the
most favorable terms for a customer’s transaction in the
SEC. Among the four proposals is the introduction of an
context of the prevailing circumstances. PFOF’s supporters
SEC “best execution” standard, which would require
assert that such trades do conform to best execution and
brokers to detail policies and procedures for achieving best
indirectly benefit investors by subsidizing low- or zero-
execution.
commission rates and other services. Some critics have
argued that because broker-dealers do not generally pass the
The SEC’s proposed PFOF reforms would require that
PFOF rebates onto their clients, they may have economic
certain individual, retail marketable stock orders (orders
incentives to send retail orders to rebating market makers,
seeking to be immediately executed at the best available
creating potential conflicts with the duty of best execution.
prices) initially routed to the wholesalers (called restricted
competition trading centers) be then routed to an open
The Current Regulation of PFOF
auction (called a qualified auction) at a specified limit price
FINRA and the Securities and Exchange Commission
(a buy or sell stock price order threshold). Open
(SEC) regulate PFOF through an array of regulations:
competition trading centers, including national stock
exchanges such as Nasdaq and the New York Stock
FINRA’s Rule 5310. Under this rule, brokers must use
Exchange (NYSE), and alternative trading systems (non-
“reasonable diligence” to determine the best market for a
exchange, electronic trading systems regulated as broker-
security and execute an order at a price that is “as favorable
dealers, which includes dark pools) would operate the
as possible under prevailing market conditions.”
proposed auction. The proposal could result in more retail
stock orders being executed on these venues.
SEC’s Regulation National Market System, Rule 606
and 607. Currently, the SEC’s regulatory approach to
Also under the proposal, when wholesalers receive a
PFOF involves disclosure rules under Regulation National
segmented order they would route it to a qualified auction
Market System (Regulation NMS). Regulation NMS
at specified limit prices. Under the rule, with some
derives from the Securities Exchange Act of 1934 and was
exceptions, segmented orders are orders for NMS stocks
a set of rules adopted in 2005 by the SEC to refine how
made for the account of (1) a natural person or a group of
exchange-listed U.S. stocks trade (known as the National
related family members (2) where the average daily number
Market System or NMS).
https://crsreports.congress.gov
Payment for Order Flow: The SEC Proposes Reforms
of trades executed in NMS stocks was less than 40 in each
competitive dimension would likely come from greater
of the six preceding calendar months.
retail order interaction by institutional investors and
stock exchanges.
After receipt of such an order, a wholesaler would then be
required to route it to a qualified auction at a specified limit
The reform could mitigate broker conflicts of interest by
price. The wholesaler could then participate in the auction.
removing broker discretion on sending orders.
If the segmented order were then not executed in full during
the qualified auction, the wholesaler would be permitted to
The reform could also help remove the competitive
execute the segmented order at or better than the specified
advantage that wholesalers have over retail orders.
limit price. Alternatively, the wholesaler could opt to return
the order to its broker client without execution.
Arguments critical of the proposal include:
Some of the Proposal’s Plausible Outcomes
According to some estimates, the amount that retail
According to the SEC
investors saved in execution price improvement from
The SEC notes uncertainties about outcomes if the auction
PFOF beyond the National Best Bid and Offer (NBBO)
proposal is implemented. However, it said that some
was in the billions of dollars in 2022. (NBBO denotes
plausible outcomes include:
the best displayed offers to buy and sell individual
stocks on exchanges at given points in time.)
Opening up retail investor orders to the order-by-order
auction-based competition could translate into
A robust trading presence by wholesalers improves the
significantly better execution prices for them, remedying
trading of less liquid and less traded securities and can
a current competitive average annual shortfall of
reduce market volatility. Even if the proposed auction
between $1.12 billion and $2.35 billion.
regime does enhance execution quality for some retail
investors, reducing the role of wholesalers could reduce
Members of national securities exchanges, which
these benefits.
currently interact with a small portion of retail investor
marketable orders, would likely be able to expand their
Marketable retail orders routed to wholesalers appear to
volume of such trades.
provide retail brokers with a high degree of consistency
regarding execution quality. Investors are also more
Institutional investors would likely get a heightened
likely to receive price improvements from the NBBO
opportunity to interact with the retail orders.
when routed to wholesalers compared to securities
exchanges.
Wholesalers would “most likely” wind up executing a
smaller share of retail order flow and see an attendant
The complicated reform would introduce problematic
reduction in profits from their interactions with such
investor trading risks, including execution challenges
orders. (However, Virtu has said that under an auction
and operational uncertainties.
system where it could more selectively bid on orders, it
might save hundreds of millions of dollars annually.)
In one study, five professors personally conducted
85,000 separate trades through several zero-commission
There could be a significant or total loss of PFOF. If so,
brokers for 128 stocks. They found significant variations
there are several reasons why retail brokers would
in execution prices away from the best posted executed
generally not be likely to return to commissions. Among
prices for transactions in identical stocks. This was
them is the fact that most brokers reportedly receive
estimated to be equivalent to tens of billions of dollars
relatively little or no PFOF, subsidizing commission-
in excess aggregate annual costs for all retail investors.
free trading through other revenue-generating lines of
PFOF, which not all the subject brokers participated in,
business. This can vary significantly from firm to firm:
however, was not found to be a significant factor in the
Robinhood is said to be exceptionally PFOF reliant,
variations. (The variations were attributed to
while some brokers take no PFOF.
wholesalers systematically giving different execution
prices for identical trades to different brokers,
Praise and Criticism
potentially raising other questions about wholesaler-
The proposed Rule 615 has earned support and criticism
broker relationships.)
from various entities. Proponents include NYSE officials
and some retail investor advocates such as Better Markets.
The proposal could wind up costing retail investors
Criticism or concerns have come from several Republican
more than it benefits them in execution price
Members of Congress, Robinhood, Virtu, Citadel, and the
improvements beyond the NBBO if it results in the
Securities Industry and Financial Markets Association (a
disappearance of zero commissions, which is said to
trade group for broker-dealers). Supportive arguments for
have saved investors billions of dollars. (The study
the proposed Rule 615 include:
described in the previous bullet found that zero-
commission brokers can, however, have excess
The proposal would benefit individual investors by
execution costs that are ultimately borne by investors.)
promoting competition and transparency to enhance the
opportunity for their orders to receive more favorable
Gary Shorter, Specialist in Financial Economics
execution prices than they currently do. An added
IF12332
https://crsreports.congress.gov
Payment for Order Flow: The SEC Proposes Reforms
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