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SEC chair Gary Gensler: Conflict 'inherent' in payment for order flow

The newly appointed stock-market regulator criticized the practice that has made zero-commission stock trading possible, saying investors are paid in other ways.

​SEC chair Gary Gensler testifies at a House Financial Services Committee hearing on Thursday, May 6, 2021.

SEC chair Gary Gensler testifies at a House Financial Services Committee hearing.

Screenshot: House Financial Services Committee/YouTube

SEC Chairman Gary Gensler, only a few weeks on the job, told members of Congress on Thursday that he's looking closely at payment for order flow and market concentration with an eye toward whether retail traders are getting a fair shake.

Gensler highlighted his agency's increased scrutiny of the markets at a hearing of the House Financial Services Committee about January's wild gyrations in GameStop shares.

Payment for order flow was an area of particular interest to committee members. Some brokers like Robinhood use the now-widespread practice to get paid by market makers for sending trades to them. Critics question whether such payments set up a conflict of interest and deprive retail investors of the best possible price for shares; proponents say that market makers deliver considerable improvement in prices.

The House committee has a draft discussion proposal to ban payment for order flow. Canada and the United Kingdom don't allow it, and a U.K. study found that the country's elimination of the practice resulted in better prices for investors.

"I've asked staff to take a closer look at this in the context of overall market structure," Gensler said. Such payments, he said, can be a "conflict with the interest" of customers and such conflicts are an "inherent" part of the system.

Payment for order flow's supporters have argued that retail traders benefit from the elimination of commissions such payments make possible. Gensler seemed unpersuaded by those arguments.

"These are not free apps. They're just zero-commission apps," he said. "The cost is inside the order execution."

Gensler also cited the Robinhood case settled in December — though he didn't name the popular online brokerage — as an example of the ability of brokers to define for themselves how much of the profit from the spread they get and how much they pass on to investors as price improvement.

"We found conflict in various enforcement cases like one we filed where the wholesaler was literally saying, 'Well, you tell me. I can pay you more — the broker — or I can pay the customer more.' We know at least from that case this inherent conflict is there," he said.

In that settlement, the SEC wrote: "[C]ertain of the principal trading firms told Robinhood that there was a trade-off between payment for order flow on the one hand and price improvement on the other: If Robinhood negotiated for higher payment for order flow revenue, according to the principal trading firms, there would be less money available for the principal trading firms to provide price improvement to Robinhood's customers."

But payment for order flow is not the whole story when it comes to best execution, Gensler said. He noted that wholesalers — which are not regulated like "lit" exchanges — have 37% to 38% of the market. The SEC is also looking at exchange rebates that the exchanges pay to brokers, which function similarly to payment for order flow, Gensler said.

Several representatives asked about system risk and the concentration of power in trading, and some asked specifically about Citadel's role as the largest market maker.

The current market structure has also led to market concentration, which can mean higher costs for investors, Gensler said. While he didn't cite scrutiny of specific firms, that could mean a closer look at firms such as Citadel, which says it is the largest wholesaler, executing 47% of U.S.-listed retail trades.

Gensler said he had asked commission staff to review "how this market structure that's led to concentration — right now we have pretty highly concentrated and growing concentration in the retail order flow. Economics tells us competition lowers cost to investors."

Short of a ban on payment for order flow, regulators said that increased disclosure about payment for order flow is also a possibility. "Fundamentally the question is, is that conflict you're describing, is that adequately addressed through disclosure?" said Robert Cook, president and CEO of FINRA. "Many investors don't understand these aspects of the market."

One infrastructure issue that regulators are looking at is reducing the settlement time for trades from two days to one. The technology to do this is already available, Gensler said. This could lower certain margin and volatility costs as much as 40%, saving the industry $6 billion a day, and the Depository Trust and Clearing Corporation is looking at different ways to do this along with industry partners, said Michael Bodson, CEO of DTCC.

Gensler also said he would look at gamification and its role in trading, noting that he's fine with a streaming service manipulating him to watch more movies — he's partial to romantic comedies, he noted — but that manipulating people to trade more isn't necessarily a good thing.

"If you use gamification features and folks are trading more actively and day trading, then all of a sudden that's their investment future," he said. "That's a challenge for their future and security. I think we have to take a look at this."

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