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The GameStop/Robinhood story has electrified the capital markets in recent weeks, and Payment for Order Flow (“PFOF”) sits at the center of the controversy. For those looking to learn or brush up on the concept ahead of this Thursday's congressional hearing, read below. 1/23
At a basic level, brokers have many choices as to where to route orders for execution. Some venues, like stock exchanges, charge your broker to execute those trades; other venues, like private trading platforms, pay your broker for the opportunity to execute those trades. 2/23
When your broker routes your order to a place that pays them, the money they receive is referred to as payment for the flow. By itself, it's a relatively simple concept. The key is to understand PFOF in context — and to do that, we need to review six essential concepts. 3/23
INVESTORS VS. TRADERS: Long-term investors are always deeply suspicious that traders who simply "flip assets" are ripping them off. Investors feel more comfortable in a “natural” market, where a buyer and a seller are paired off, with no middleman. 4/23
The problem is natural markets aren’t necessarily efficient. If you want liquidity, you need different kinds of firms with different goals, strategies and time horizons. Ideally, you have firms willing to buy and sell assets all day long. You need market makers. 5/23
MAKING MARKETS: In simple terms, a firm that makes a market in a stock is willing to buy or sell that stock at any time. A market maker offers a two-sided quote, a bid at which they are willing to buy the stock and an ask at which they are willing to sell. 6/23
If a market maker is quoting $12.00 by $12.10 for a given stock, it will sell it for $12.10 and buy it at $12. That 10-cent spread is how market makers stay in business. With spreads being only pennies, they have to do lots of trading, so they value order flow. 7/23
INTERNALIZATION: When a brokerage firm receives an order to buy 100 shares of a given stock, and then receives an order from a different client to sell 100 shares of that same stock, the broker can bypass exchanges and match the order itself. This is "internalization." 8/23
Why internalize? The exchange will charge you a fee for executing each side of the trade, but it’s free if you do it yourself. If you run a big brokerage firm that has many clients buying and selling, internalizing some of your order flow can represent quite a savings. 9/23
While not entirely the same, the terms "market maker" and "internalizer" are often used interchangeably. What’s true is that market makers can internalize a higher percentage of trades and reap the benefits. This incentivizes smaller firms to stand up their own MM units. 10/23
This is doable, but it's still hard to compete with the behemoths. Instead, many smaller firms choose to route to large firms that specialize in market making, which are profitable enough to give PFOF in exchange. Various versions of this idea exist throughout the industry. 11/23
PRICE IMPROVEMENT: Let's say a broker with a PFOF agreement receives simultaneous buy and sell orders for a stock priced at $12 by $12.10. When a market maker receives the order, it executes the purchase at $12.09 and the sale at $12.01. This is known as price improvement. 12/23
So:
- The market maker made an $0.08 spread
- The broker saved the fee of routing the orders to the exchange, and received PFOF from the market maker (which comes out of the money it made on the spread)
- Customers got a price better than what was publicly displayed
13/23
- The market maker made an $0.08 spread
- The broker saved the fee of routing the orders to the exchange, and received PFOF from the market maker (which comes out of the money it made on the spread)
- Customers got a price better than what was publicly displayed
13/23
Everyone wins! Well, maybe not everyone. The entities directly involved win, but some would argue that having this trade occur off-exchange harms the market overall. That’s part of the PFOF controversy. 14/23
BEST EXECUTION: By SEC rule, brokers are required to get the best possible trade execution for customer orders. Given how many factors go into the price of a security, it is extremely difficult, if not impossible, to definitively identify the “best” possible execution 15/23
Fast-forward to 2021: GameStop/Reddit/Robinhood is all over the headlines, and among the myriad issues being scrutinized is PFOF. As you can tell, it's a multi-layered issue, there are essentially two arguments against the practice. 16/23
ARGUMENT A: Brokers are obligated to get clients the best execution possible, so an incentive to route trades to one venue over another is a non-starter. Even if investors benefit, the broker might have routed to a venue offering even more price improvement if not for PFOF. 17/23
COUNTERARGUMENTS: Regardless of where you fall on the issue, PFOF does little material harm to investors while enabling brokers to democratize trading by allowing accounts with no minimums, commissions, etc. Issues with best execution have already been addressed by the SEC. 18/23
ARGUMENT B: PFOF segments the market in a way that harms the market overall, incentivizing nearly all retail flow to be routed off-exchange, causing a liquidity shortage that may increase trading costs. Trading off-exchange also harms price discovery 19/23
COUNTERARGUMENTS: If the premise is that off-exchange trading is harming the overall markets, then why limit the discussion to PFOF? Crossing networks and dark pools also take order flow away from exchanges. If this is a legit concern, PFOF is just the tip of the iceberg. 20/23
If only PFOF is curbed and everything else remains, there will be a host of expected and unexpected consequences. It would most likely tilt the playing field in favor of larger firms. Inevitably, that would lead to further consolidation and fewer choices for investors. 21/23
Finally, we have been down this road before. The PFOF controversy comes up every few years, and the SEC has ruled that while the practice does raise the potential for a conflict of interest, it does not address best execution requirements. 22/23
It will be fascinating to see how this story plays out in the weeks and months ahead, and we look forward to helping you stay informed. For a more detailed version of this explanation, check out our website: https://forefrontcomms.com/2021/02/16/pfof-rafi-reguer/ 23/23
