SEC Announcement Sees Regulators Targeting Payment for Order Flow

  • The U.S. Securities & Exchange Commission (SEC) is preparing changes to the payment for order flow (PFOF) model.
  • SEC Chair Gary Gensler has taken an interest in cracking down on market makers paying exchanges to execute their trades.
  • Much of the concern over PFOF has ramped up in response to last year's meme stock fiasco involving Robinhood (HOOD).
An emblem at the U.S. Securities and Exchange Commission in Washington, DC.
Source: Mark Van Scyoc / Shutterstock.com

Gary Gensler has beef with payment for order flow (PFOF). The conflict seems to be coming to a head, though, as Gensler speaks at the Piper Sandler Global Exchange Conference. The SEC Chair has been looking into this particular model of trade execution since taking the helm of the agency. Now, Gensler and the SEC are coming up with a plan to disrupt PFOF transactions and better protect retail investors.

PFOF is a method of clearing trades. Under PFOF, brokers sell their users’ trades to specific market makers, who execute the trades and return the proceeds to the broker. It’s the model of choice for many e-trading platforms. Robinhood (NASDAQ:HOOD) first made PFOF famous, offering free trades to users. The massive success of its model led others to take on PFOF, or risk falling out of favor with users.

On the surface, this model may seem to be good for traders. But it is not without its faults. PFOF has been controversial even from its founding; the idea was first thought up by Bernie Madoff. Many believe PFOF violates the Financial Industry Regulatory Authority’s (FINRA) “best execution” requirements. Essentially, allowing brokers to dictate flow of trades enables brokerages to put their own profits over minimizing the bid-ask spread in trade execution.

The shadier aspects of this model have come on full display this past year. After hedge funds lost billions in the wake of GameStop’s (NYSE:GME) run, Robinhood put a halt on GME trading as well as other meme stocks. Investors took this as evidence of the company’s allegiance to Ken Griffin’s Citadel Securities, one of the largest market makers for Robinhood. Citadel Securities is the sister company to Citadel, which helped bail out fellow hedge funds after their GME short positions soured.

SEC Announcement Sees Gensler Fighting Off PFOF Models

Today’s SEC announcement is the culmination of months and months of drama, research and deliberation among lawmakers and regulators. The meeting this afternoon sees Gensler advocating for a new trade execution model which can better serve retail traders.

The proposals Gensler is fielding this week would make for some of the broadest changes since the market crash of the 2000s. The SEC Chair wants to see brokerages and market makers held to providing investors with the best execution possible. Right now, he doesn’t believe that’s what they’re getting.

After considering a ban on PFOF last year, it looks like Gensler is no longer comfortable with fully banning the model. Instead, he’s outlining the creation of a new mechanism for trade execution. This model would take on an auction format, in which market makers bid on trades order-by-order. The model is similar to what exists in the options trading market.

Other planned PFOF reform includes setting minimum, market-wide tick sizes which market makers must adhere to. This would prevent them from choosing poorer execution for investors in order to pocket higher revenues.

These proposals are expected to be fully outlined this fall. Some market makers, like Citadel Securities, have expressed caution. However, they say they will work with the SEC to implement agreeable changes to the market.

On the date of publication, Brenden Rearick did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.


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