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US regulators want to reform the controversial Wall Street trading practice known as “payment for order flow”, whereby retail brokers collectively make billions of dollars a year selling their customers’ orders to the country’s biggest trading firms.

The Securities and Exchange Commission has been looking at the inner workings of share trading in the US after pandemic lockdowns prompted an explosion of activity among private retail investors.

That surge of interest culminated in dramatic spikes in the prices of popular so-called meme stocks, such as GameStop, last January — and the imposition of trading restrictions by some firms. These halts in trading drew fire from politicians in Washington, and the attention of Gary Gensler, chair of the SEC.

Now, the SEC’s gaze has fallen on payment for order flow, or PFOF. Popularised by the disgraced investor Bernard Madoff, the practice has become deeply embedded in the daily workings of US share trading.

That is in part because more retail investors in the US buy and sell directly in the market than is the case in other countries, and the standards that ensure retail investors are not disadvantaged when trading are codified in US securities law.

PFOF involves popular retail brokers — among them TD Ameritrade, Robinhood, E*Trade, and Schwab — selling their customers’ orders for a small fee to market makers. These market maker firms — such as Citadel Securities, Virtu Financial, and Susquehanna International Group — act as wholesaler intermediaries, by buying and selling shares all day and quoting prices to entice others to trade. As wholesalers, they are obliged to execute trades at, or at better than, current market prices.

However, the PFOF process is controversial. Brokers argue that the system means retail investors get a better overall deal, since the brokers can charge lower or zero commission for trading, as they get paid for passing on orders. But regulators are concerned that this creates a conflict of interest, since the broker may be incentivised to sell their customers’ orders to the highest bidding wholesaler.

Brokers earned a record $3.8bn last year from payments for their orders, up from $2.8bn the year before, according to monthly regulatory filings collated by Bloomberg.

Last year’s mass trading of GameStop shares, and other meme stocks, has also raised concerns among regulators that unwary retail investors are being lured into the market by apps that encourage the “gamification” of buying and selling. Apps can make use of email alerts, prompts, and moving images to persuade users to trade. Retail trades accounted for about one in five of all trades on US equity markets in 2021 — nearly double the level in 2018.

the Game Stop logo is seen displayed on an Android mobile phone
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For the SEC, the issue revolves around whether retail investors are better off under these private arrangements between retail brokers and wholesalers, or not. The industry debate has been vociferous.

Doug Cifu, chief executive of Virtu Financial, has argued that the system benefits investors and that forcing trading on to an exchange would result in the transfer of $11bn a year from retail investors to professional traders.

Similarly, in a report in February, trading technology firm BestExResearch suggested there was “nothing evil about allowing retail market order flow to go to wholesalers”. It estimated that investors got a price that was up to 15 per cent better than that available on an exchange, when technical factors were taken into consideration. But moving the orders on to a public market would probably have even more benefits for investors, it added.

At present, the SEC appears to be moving towards reform of the system. Gensler said last summer that an outright ban was “on the table”. Then, in a recent speech, he outlined a proposal to create a competitive auction system for investors’ orders and hopes to have something in place by the end of the year.

SEC officials have already floated the idea of an auction mechanism with tougher minimum standards on trading with exchanges and fund managers. Cifu has called on the SEC to discuss untested proposals with all market participants.

For the moment, though, little has been resolved. Kyle Voigt, an analyst at investment bank KBW, has pointed out that it was impossible to work out the financial impact on brokers until the specific details were available.

But some are already anticipating a future in which PFOF plays only a small role in trading. FTX, the cryptocurrency exchange, has said it will not accept payments for its order flow when it begins stock trading.

“The prospect of major regulatory shifts in equities market structure is among the reasons we chose not to pursue a PFOF model for FTX’s stock trading platform,” tweeted Brett Harrison, president of FTX US.

“A shift that requires firms like Virtu and Citadel to compete in public, open auctions for retail flow would bring transparency to the market, lower the barrier to entry for new wholesalers, and likely profoundly alter the current trend of liquidity moving off-exchange,” he added.

Even if concrete policy is still months away, the market is anticipating change.

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