Improving stock market efficiency can hardly be seen as a bad thing by investors but the path to doing so can be complicated.
Promoting competition with as few regulations as required is often seen as the way to improve market efficiencies. Rules can come with unnecessary costs that are paid by both the seller and buyer and can be skewed towards one side depending on the actual regulation. However, rules are still needed as otherwise smaller and less sophisticated players can be manipulated in a multitude of ways.
How are Brokerages Making Money?
Stock markets have come a long way in improving efficiency over the past hundred years. Investors no longer have to pay a multitude of fees for every option contract they enter or flat fees for stock trades even. However, investors still have to pay a price for any trades they initiate on Robinhood (HOOD) or Fidelity, it's just not as obvious as a set fee.
Just because Robinhood isn’t charging its customers a fee doesn’t mean it is making trades out of the goodness of its heart. Many brokerages by selling orders to wholesalers, which are mostly high-speed trading firms. These firms pay the broker and then make money off the bid-ask spread. The spread is usually very small but when done over thousands, or millions, of trades adds to a hefty little sum. Robinhood and many others accept compensation for sending trades to these firms. While that may immediately seem like a red flag, these brokerages often argue that wholesalers provide the best price.
Issues with Current System
This payment of order flow has been under fire from Securities and Exchange Commission (SEC) Chairman Gary Gensler as he says it creates a conflict of interest between brokerages and their customers. The European Union is considering a ban on the practice while the United Kingdom, Canada, and Australia have already outlawed it. Thus, the SEC is considering increasing competition by having firms compete for an individual investor’s trade instead of just being sent to one wholesaler for compensation.
Another issue is that the “best price” offered by wholesalers compared to exchanges is often just a hundredth of a penny different from what exchanges offer. Wholesalers are able to undercut like this because they can fill orders at sub-penny prices while exchanges are limited to a tick size of one-penny increments. This difference in regulation provides an unfair advantage for wholesalers, thus, Gensler is calling for exchanges to be able to price in sub-penny increments.
Additionally, Gensler called for disclosure of execution quality so that investors can compare order executions across brokerages. Further raising competition and allowing investors to receive the best possible order execution. To go along with that, the Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB) both have rules on best execution while the SEC lacks such a rule.
Brokerages Defense of Current Policies
The main defense brokerages have issued against the SEC for these proposed changes is that costs have been reduced for retail investors and that the current structure has resulted in tighter spreads and the lowest barriers to entry the stock market ever seen. This seems like a pretty reasonable counter argument as conditions have absolutely improved recently and the current structure is doing at least an adequate job for most.
However, just because something is good to great doesn’t mean it can’t be better. The current system could be the very best ever and still be improved upon. A certain 7-foot giant proved that when he decided to join a 73-win Golden State Warriors. Spreads are certainly tighter than ever in stock markets while fees are lower across the board but that can be further improved with the promotion of increased competition and elimination unnecessary rules for exchanges but not wholesalers.
Outside of that, Citadel and Virtu Financial (VIRT) have cited the payment from wholesalers as a primary reason for the lower costs to investors while an order-by-order competition system that increased trading firm discretion could actually hurt investors with wholesalers making higher profits.
Wrapping Up
The payment for order flow dynamic with wholesalers compensating brokerages for trades has its pros and cons with reasonable arguments on both sides. It would need to be seen in practice whether a different system could lower costs to investors and further improve efficiency.
Gensler’s other recommendations are far less arguable as wholesalers should not have a competitive advantage when it comes to tick sizes and being able to offer the best price just because they play by different rules. Additionally, it's hard to argue against further disclosure from brokerages to investors so that portfolio managers can compare executions across platforms. The disclosure may be more complicated than some investors desire but having the option for those who want it is a positive change. Lastly, the SEC having its own rules for best execution may improve the commission’s ability to enforce regulations that promote competition and fair use.
