At a conference last week, SEC Chairman Gary Gensler spoke of the need to reexamine the current market structure and questioned the outsize role currently played by market makers and private exchanges. At the core of his concerns is the near-ubiquitous practice of payment-for-order-flow, whereby market makers pay retail brokerages fees to have the retail brokerages’ customer orders routed to them instead of a public exchange.
The downstream effects of payment-for-order-flow are significant. The additional revenue stream to retail brokerages (e.g., E*Trade) have enabled them to eliminate the fees they traditionally had charged their customers whenever they trade, to the point that zero-commission trading is now an industry standard for retail brokerages. The removal of that barrier to entry has unsurprisingly increased the number of unsophisticated investors participating in the markets, as well as the frequency and aggressiveness with which they trade—things made glaringly apparent by the “meme stock” frenzy earlier this year.
But Gensler sees a deeper problem in payment-for-order-flow, namely that its proliferation has siphoned a significant portion of all market activity away from the public exchanges, which are still the source of benchmarks like the National Best Bid and Offer (NBBO). Almost half of all market activity is now conducted in non-public venues, either through payment-for-order-flow arrangements between market makers and retail brokerages, or in private “dark pools” run by institutional brokerages (e.g., Goldman Sachs). With so much trading happening “in the dark,” market benchmarks like the NBBO are therefore derived from a dataset that is scarcely more than half what it otherwise could be. That incompleteness is what underlies Gensler’s statements to the effect that the NBBO may be a “substandard benchmark” and “not a complete enough representation of the market.”
The NBBO is important because it sets the minimum sell and maximum buy prices for all securities transactions, both on public exchanges and in dark pools or through payment-for-order-flow. That means that when an investor trades through a retail brokerage with payment-for-order-flow, their order will be filled by a market maker at a price within the NBBO.
Presently, the NBBO for each stock is simply a matter of the highest bid (buy price) and lowest offer (sell price) for that stock on a public exchange at any given moment. Gensler says the SEC will explore calculating the NBBO differently, which would presumably entail bringing at least some “dark” market information into the light.
Market-making entities contend that payment-for-order-flow is a boon to retail investors, as it not only can lower their upfront fees of investing but also allows them certain buying and selling advantages not possible on the public market, like “price improvement” and “enhanced liquidity.”
Payment-for-order-flow thus presents as something like an intrinsic good, offering individual investors better prices and lower fees and retail brokerages increased revenues and customer bases. But Gensler’s concern is that by taking so much of the total market activity away from public exchanges, the NBBO has become a less reliable proxy for the true price of a stock at a given moment, and therefore the supposed advantage of “price improvement” may be illusory. Gensler even stated that payment-for-order-flow “raise[s] questions about whether investors are getting best execution,” and noted that the practice is banned in several countries, including Canada and the United Kingdom.
It will be interesting to see what action the SEC ultimately takes, as the consequences of any meaningful change to payment-for-order-flow or the calculation of the NBBO will undoubtedly be far-reaching and consequential to virtually every market participant, big and small. To be certain, if any change impacts market makers’ bottom lines, it is not hard to predict that the days of zero-commission trading may come to a screeching halt.