Regulators are going after payments for stock orders. What about crypto?

The SEC is concerned about payment for order flow in stocks and options. But crypto, which it is struggling to regulate, is a "Wild West."

Bitcoin illustration

What are you paying for your bitcoin?

Illustration: Jeremy Bezanger / Unsplash

Two of the SEC's major concerns are payment for order flow, the potentially conflict-ridden system where retail brokers get paid by market makers for sending them orders, and cryptocurrencies, the largely unregulated digital tokens that are generating a booming market in speculative trading.

What if you put them together?

That's not a hypothetical question: Robinhood, the online broker that recently went public, is already making more money from crypto payment for order flow than any other source.

SEC Chairman Gary Gensler has said the agency is scrutinizing payment for order flow, a decades-old business model that is used by large brokers like Schwab and TD Ameritrade but that Robinhood has finessed into profitable perfection. Regulators are considering all options including a ban on such arrangements, with Gensler noting that conflicts are "inherent" in a system where market makers pay retail brokers for directing trades to them, in effect splitting profits that come at investors' expense.

Cryptocurrencies were designed for peer-to-peer transactions, bypassing middlemen and marketplaces. But marketplaces have arisen nonetheless, facilitating buying and selling much like stock and currency markets do. And Robinhood, in particular, is championing the idea of extending the payment for order flow model to the crypto world.

The scope of the issue became clear when Robinhood reported that payment for order flow from crypto trading made up more than half of its second quarter transaction revenue, representing 51.7% or $233 million. That's way up from 20.8% of transaction revenue in the first quarter of 2021 and just $5 million a year ago. The runaway growth in crypto might have been less obvious had it not been for a slowing of the meme-stock craze right as interest in crypto took off.

This also has meant a shuffling in Robinhood's partners. Jump Trading's Tai Mo Shan Ltd. paid Robinhood $164 million for crypto orders in the second quarter. Robinhood's relationship with Citadel, a primary partner for stock and option payment for order flow, has gotten considerable scrutiny. But the broker's relationship with Jump Trading has drawn less attention, even as its payments exceeded what Robinhood has ever gotten from Citadel in a given quarter according to researchers at Alphacution Research Conservatory.

It's not clear that crypto payment for order flow is even on the SEC's radar, or if it could even regulate the practice, since crypto markets are not currently regulated as exchanges. Gensler has articulated a desire for Congress to give the SEC broader authority over crypto, but it's not clear when a broader regulatory remit might come.

Regulators could come after crypto brokers, but "right now all they can do is saber rattling," said Paul Rowady, founder of Alphacution. At most, the agency might go after "domestic brokers that are engaged in retail activity in the crypto market," he added.

Even then, much of the parceling out of trades is happening internationally, he said: "It's the Wild West. It's a global market with cross-border activity. Even U.S. entities potentially are engaging with crypto infrastructure that's non-U.S. That puts U.S. regulators at a disadvantage because they don't have jurisdiction."

Dealing with that "will require a coordinated effort with a global consortium of regulators, which will take a lot of time," he added.

In this fast-growing crypto market, there is little guarantee that retail investors are getting the best prices on trades. Crypto spreads can be much bigger than equities, providing more opportunity for market makers and others to profit off of retail investors.

In equities and options, brokers and market makers must disclose in public reports to the SEC who they send trades to and how much they make. Through such reports, we know Robinhood made four times as much in payments for each S&P 500 share traded as Schwab did in December 2020. Such disclosures don't exist for crypto, so it's all but impossible to know who's profiting and how much they're making.

Robinhood, for its part, has said payment for order flow in crypto enables commission-free crypto trading, which gives investors the cheapest total cost. The company declined to comment on the record for this story.

Robinhood says it doesn't route crypto orders based on payments market makers provide. "We receive uniform volume-based rebates from trading venues, but never consider rebates when deciding where to route your order," Robinhood wrote in a June blog post.

Robinhood says that its buy orders are executed as a limit order with a 1% collar to ensure prices don't differ wildly from what traders expect.

Coinbase, for its part, charges retail investors a fee of up to 1.49% plus a set fee that varies based on the size of the order. It sends retail trades to execute on its Coinbase Pro exchange, so there is no payment for order flow.

There remains the question of whether retail investors are getting the prices on crypto trades. In the equities and options world, there is the National Best Bid and Offer, an official record of the best price available on exchanges at a particular moment. The NBBO is flawed and imperfect, since it doesn't actually reflect the best price to be found anywhere — market makers operate their own liquidity pools that can yield better pricing unavailable on exchanges — but it is a formal benchmark that brokers and exchanges can be measured against. Brokers and market makers are obligated to execute most trades close to the NBBO, but often, substantial profits can be made within the NBBO spread.

In the crypto world, because crypto exchanges are not regulated as exchanges, there is no NBBO and there is no official record of the best price.

So how do investors know what they're getting? The largest brokers tend to set the prices, some experts said. Genesis Trading, for example, is one large prime broker that can set the market price, according to one crypto expert.

But spreads in crypto markets vary widely, particularly between different exchanges. There are entire trading firms that focus on arbitrage between exchanges.

As a result, large investors that are trading large blocks of crypto go to a firm like Genesis to execute trades. Those firms then break down those trades and execute them in myriad ways, depending on how big they are and how fast they need to be executed. These include trading with other brokers, sending it to exchanges such as Coinbase's or taking on the trades internally.

Small retail investors don't have a prime broker who can get them the best trades.

This frontier wildness won't last forever. Crypto companies in the U.S., as they mature, will seek to make nice with regulators, Rowady said. "There is a self-regulating nature to all this," he said. "There's legal exposure if a fiduciary doesn't make all the effort to find the best prices and best execution."

That self-interest will force institutions to make some changes, he said.

But for now, it's crypto buyer beware.


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