Gary Gensler, chairman of the Securities and Exchange Commission, is out to kill payment-for-order-flow (PFOF), the misunderstood retail trade routing mechanism that birthed commission-free trading while enriching a few love-to-hate brokerages and Wall Street scapegoats.

But killing PFOF could kill retail trading and investing, the greatest, most equalizing, easiest to access, wealth creation avenue for all Americans.

This is a big story, but the circus surrounding the 75-basis-point rate hike yesterday has swept it under the rug along with all the opportunities it will present to investors. So, I wanted to take the time in today’s Total Wealth to address what this means for you and what you can do about it.

All There is To It

Payment for order flow isn’t complicated or nefarious; it’s only misunderstood due to false accounts of what it is and isn’t.

Brokerages from E-Trade and Charles Schwab, to TD-Ameritrade and Robinhood, all get buy and sell orders from their retail customers that have to be executed. These brokerages don’t have their own trading desks like Goldman Sachs, Morgan Stanley, or Merrill Lynch. Instead, they route their customers’ orders to trading desks that can execute them.

Since chosen execution desks pay brokerages to route them their retail customers’ orders, so they can take the other side of those trades or reroute them to an exchange, brokerages willingly sell their order flow.

It’s precisely because so-called “discount brokerages” are being paid for their order flow that they can offer commission-free trading for execution services that actually cost brokerages money.

That’s all there is to it. But how we got here is another story.

A lifetime ago, all orders to buy and sell stocks in America were sent to the Floor of the New York Stock Exchange (NYSE), because that’s where public companies shares were traded. Then the American Stock Exchange (AMEX) opened up to compete with the NYSE, then other exchanges followed.

In the modern era, the NASDAQ (National Association of Securities Dealers Automated Quotations) offered trading over computer networks as opposed to sending orders to the floors of exchanges. In the 1990s, small electronic communications networks (ECNs) sprung up, privately owned electronic exchanges seeking to compete with all the physical and cyber-exchanges vying for orders to be executed at their venues for small fees.

The unintended consequence of all that competition was “thinner” markets as orders that used to be concentrated in one place were spread around different venues, most of whom traded the same stocks. That fragmentation meant different exchanges and networks would often have different bid and offer prices for the same stocks, which made it hard for traders to find the best prices to trade at.

In 2005, the Securities and Exchange Commission passed Regulation NMS (National Market System) which included NBBO regulations. NBBO stands for National Best Bid and Offer. It mandated that all venues that displayed public quotes post the best bid and best offer for every stock they quote that can be executed at that venue, no matter where the best bid or offer originated. Then, not only could the public see through all the different venues and know what the highest bid for a stock was and what the lowest offer was, trades on any of the venues had to be executed at the best bid or offer even if the executing venue wasn’t where the NBBO was.

Disingenuous Muckraking

Opponents of PFOF, like Gary Gensler and Dennis Kelleher (the president and CEO of non-profit Better Markets, who along with Gensler served on the Biden-Harris transition team) claim brokerages that sell their order flow aren’t getting the best price for their customers’ orders. But that’s rubbish. Executing market-makers like Citadel and Virtu Financial who both buy order flow, have to execute orders at the NBBO. In fact, they often execute orders with “price improvement,” or at better prices than the NBBO.

But PFOF bashers like Kelleher, in a widely watched Fast Money interview in July 2021, claim those customers are still getting ripped off. How? Because Kelleher says the NBBO isn’t the best price, that there’s a “spread within the spread” he rails, and executing trade desks are giving price improvement based on that inside spread. Kelleher claims insiders define best execution as the NBBO knowing that it’s not the best price, so claiming filling orders at the NBBO or even with price improvement is “fundamentally misleading, if not outright fraud.”

That’s lame. Note to selves misters Kelleher and Gensler, the SEC defines NBBO as the best price. If there’s a better price and an executing market-maker or a Virtu fill an order at a better price than the NBBO, who’s that misleading?

Just because executing trade desks fill orders at their NBBO or better and still manage to turn a profit of a half penny or a penny which they split with the discount brokerage that’s “selling their order flow” doesn’t mean anything nefarious is going on.

Customers are getting the NBBO or better, and because brokerages are getting paid for their order flow, they’re executing their public retail customers orders completely commission free.

It’s really much ado about nothing. Unless you see it for what it is, a political hack job to garner public attention towards Democrats screaming the public’s being ripped off and they’re coming to save the day.

What’s ultimately misleading is how Gensler, et al, are planning on curing the curse of payment for order flow. Gensler wants an auction system, where the discount brokers customers’ orders are sent and anyone who wants to fill those orders jumps into the electronic auction site and bids up or offers lower to fill that order. Which would work.

But…unless the SEC plans on killing all PFOF and forcing all orders to be routed to an auction venue, the “fix” will just be another venue that competes with already well-working and worthwhile execution systems.

In my humble opinion, the ability to trade and invest in stocks is probably the greatest most egalitarian, most easily accessible avenue for any American or anyone to generate wealth, in the history of the world. And making that access ramp free, on account of PFOF, is a blessing not a curse.

That’s why Gary Gensler’s wannabe save the world from PFOF political circus will be unmasked for what it really is, a waste of time and resources that would be better spent going after real insider crooks.

So, how can you make money on this political stunt? Easy.

Virtu Financial (VIRT) is a high frequency trading shop that’s publicly traded. Since VIRT buys order flow it’s being viewed negatively as being in the SEC’s crosshairs. So, its stock is getting hit.

And it will likely keep going lower as the rhetoric from Gensler and the likes of Kelleher get louder and louder as the staff of the SEC pushes ahead with rules proposals to establish auction sites and try and kill PFOF.

They may even get to the point, possibly in the fall right before the election of course, where a draft rule is sent out for public comment.

Your opportunity is in buying VIRT close to its lows ahead of any draft rule being trumped out, because while there may never be a rule on account of brokerages lobbying against one, even if a draft rule makes out of the SEC, it won’t be the end of PFOF, it will merely be another venue for splintering orders.

PFOF isn’t going anywhere, but Virtu is. It’s going to go right back up when the big top of this political circus comes crashing down.


— Shah

Source: Total Wealth