(soft tense music)
- [Reporter] In February, Congress, grilled executives
from Robinhood and Citadel Securities
over their role in the GameStop trading frenzy.
And throughout the hearing,
a phrase came up over and over again.
- Payment for order flow.
- With respect to payment for order flow,
we simply play by the rules of the road.
- [Reporter] Payment for order flow
is a decade-old practice that's at the heart
of how commission-free brokers operate,
and it's creating controversy.
Critics claim that the practice creates
a conflict of interest that is bad for investors.
- While it may enable free commissions and explicit costs,
there are implied costs we feel everyone ignores.
- [Reporter] But supporters say
the practice is misunderstood
and that it's actually good for investors.
- Whether you're a Robinhood client or a Fidelity client,
you're getting a price that is at or better
than the national best bid or best offer, right?
That's the thing. - Well, lemme ask-
- There's nothing nefarious going on here.
- [Reporter] Following the GameStop episode,
the SEC is expected to conduct a review
that could change the rules of payment for order flow
and how brokers operate.
(soft tense music)
When an investor buys a stock
on a commission-free trading app,
the transaction is executed almost instantly.
But a lot is going on behind the scenes.
Let's take a look at the main players.
There are buyers,
the investors who want to purchase a stock,
and there are sellers,
the investors who want to unload a stock.
There's also the broker,
the firm that accepts investors' orders
and make sure they get executed.
And finally, there are the market makers,
which buy the orders from the broker and execute them.
These are usually high-frequency traders
like Virtu Financial and Citadel Securities,
and they are the players
that make the trade actually happen.
- When you're the investor and you're buying,
the market maker's selling.
If you're the investor and you're selling,
the market maker is buying.
But the market maker hopes to do a lot of little trades
all day long and eventually arrive at a place
where they're flat.
- [Reporter] Zero commission brokers make money
by selling customers' orders to market makers.
This is payment for order flow.
The practice enables trades to be executed
at a high volume very quickly.
It also means that most orders entered by small investors
never get sent to public exchanges
like the New York Stock Exchange or NASDAQ.
Instead, small investors' orders get executed privately
by market makers.
Let's break down how the process works.
Say an investor wants to sell 200 shares of a stock,
so they place an order with a broker.
The chances that another person
wants to buy that exact amount of shares
at the same time is pretty low, but that's okay
because the broker routes the orders to a market maker.
The market maker fills it within a fraction of a second,
but that comes with risk,
the risk that the price of the stock could fall
before the market maker can sell the 200 shares
to someone else.
The market maker is paid for taking on this risk
through what is known as the bid-ask spread.
You can see it here.
The spread is the difference in price
between what buyers are paying for a stock
and what sellers are selling for it.
It doesn't usually amount to much.
On stock exchanges, it's often just a penny per share.
When market makers execute trades privately,
the spread can be even tighter.
This is because the prices can be in fractions of a penny.
Say, using our example,
that the spread is just half a cent.
So buying and selling those 200 shares
would make the market maker $1.
But as millions of shares are traded,
the profits from the spread add up.
- It's easy money for them.
The retail investors are small,
they don't place very large orders,
and they don't tend to be extremely well-informed
about the movements of the stock price.
- [Reporter] In 2020, these brokerages collected
almost $2.6 billion in payments for stock and option orders.
And this is part of what's driving the current controversy
over the practice.
Some critics say that payment for order flow
creates a conflict of interest between the broker's duty
to seek the best execution for trades
and its desire to maximize its own profits.
- In the US, brokers have
what is called a duty of best execution.
They have to get you the best possible execution
on your trades, or at least attempt to do so.
If a broker is taking a lot of money
in payment for order flow,
then odds are it's not really giving you a best execution.
- [Reporter] Critics say this is because
brokerages could be tempted to send customer orders
to the market centers that pay them the biggest rebate
or that brokers could be demanding greater payments
from the market makers.
This is why the practice is banned
in some other countries like the UK.
- In other countries
where payment for order flow is illegal,
everything has to go to exchanges
so everything is in the lit markets
where everybody can see the prices coming together.
All the trading happens kind of out in the open.
- [Reporter] Some critics even worry that market makers
could be front-running investor stock trades,
but supporters say these claims aren't true.
Brokers and market makers argue
that payment for order flow often gives investors
a better price than the best market price
and that it helps make trading easier.
- So payment for order flow has a very big benefit
for investors, and that is, it has allowed the emergence
of zero commission trading.
It was just a few years ago
that brokers were typically charging 4.95, 7.95 or more
for a single stock trade.
A couple of years ago that went away
Robinhood set the practice, and then a bunch of others
like Schwab, TD Ameritrade, E-Trade following.
- [Reporter] In the past, the SEC has approved
of payment for order flow
as long as brokers make certain disclosures,
like where they're routing investors' orders
and how much they're getting paid for them.
The agency has said that small investors
generally get better prices when their orders are sent
to market makers rather than exchanges.
But the volatility in GameStop is raising alarms in Congress
where lawmakers are calling for fresh scrutiny
of payment for order flow.
In February, SEC Acting Chairwoman Allison Heron Lee
wrote a letter showing support for a wholesale review
of the practice.
- If the review uncovers any sort of abuses,
what I think is most likely going to happen
is that the SEC will require some sort of new disclosures
coming out of brokers and maybe out of market makers.
If payment for order flow were banned,
market makers would still be able to make money.
After all, they're still doing the same thing,
collecting the bid-ask spread.
However, the thing that would likely change
is that zero commission trading would be endangered.
- [Reporter] As the GameStop saga continues to unfold,
the future of payment for order flow
and zero commission trading remains uncertain.
(soft tense music)