Retail investors get free trades because wholesale market makers pay retail brokers for the privilege of trading with their customers’ orders, which means that the retail brokers can make lots of money without charging commissions. They get good execution because it is very pleasant for those market makers to trade with retail orders, which are less dangerous, less likely to suffer from adverse selection, than institutional orders on the stock exchange, and the market makers compete with each other to execute those orders efficiently, and if they do not give retail orders good execution then the retail brokers will send the orders to other market makers. I am not going to rehash this in detail because nobody ever changes their mind, but I have written about it extensively here.
Everybody is mad about it because it seems fishy. Surely if market makers are paying retail brokers for order flow it is because they are up to no good. The market makers seem to be getting pretty rich, while the retail traders often … aren’t. And certainly it seems like a conflict of interest: If the retail brokers are getting paid to send their orders to market makers, how can you trust that they’re doing the right thing for the retail orders?
So now everything is going to be different:
The Securities and Exchange Commission is preparing to propose major changes to the stock market’s plumbing as soon as this fall.
Chairman Gary Gensler directed SEC staff last year to explore ways to make the stock market more efficient for small investors and public companies. While aspects of the effort are in varying stages of development, one idea that has gained traction is to require brokerages to send most individual investors’ orders to be routed into auctions where trading firms compete to execute them, people familiar with the matter said. …
The most consequential change being discussed would affect the way trades are handled after an investor places a so-called market order with a broker to buy or sell a stock. … Under the auctions being considered by the SEC, different firms would compete with each other to fill an individual investor’s trade, according to people familiar with the agency’s plans. Such a mechanism would fundamentally alter the business model of wholesalers, which can make more money by trading against small investors than they do on public exchanges, where they might find themselves trading with other sophisticated trading firms or institutional investors.
Will this be good for retail execution? The wholesalers say no, though they would:
Doug Cifu, Virtu’s chief executive officer, said the SEC should be careful not to make changes that unintentionally make trading more expensive. “Order-by-order competition enables selective competition because it removes the retail brokers’ ability to demand best execution from wholesalers on every order,” he said in a statement.
“The current market structure has resulted in tighter spreads, greater transparency, and meaningfully reduced costs,” a spokesperson for Citadel Securities said in an emailed statement. “We look forward to reviewing the proposals and working with the SEC and the industry towards our longstanding objective of further improving competition and transparency.”
And nobody exactly says yes. And yet everyone is mad about the current system, so I suppose scrapping it and starting over is a political winner.
Also the potential bad outcome here is that retail investors will get worse execution or won’t be able to trade for free, and I am not sure that the SEC would mind that. “The SEC commenced its review of market structure after the frenzied trading in GameStop Corp. and other meme stocks in early 2021 brought fresh scrutiny to the handling of individual investors’ trades,” and honestly it would be very weird if a securities regulator’s main takeaway from GameStop was “we need to improve the execution quality of retail stock orders.” The problem with GameStop, to a regulator, was not that spreads on retail GameStop orders were too wide; it was that too many people were buying GameStop at seemingly irrational prices. One could imagine the SEC wanting to rewrite the rules to add frictions to retail trading, for instance, by restructuring the payment-for-order-flow model to make it harder to offer commission-free retail trading. If the retail trading experience got a bit worse, there might be a bit less retail trading, and deep down that might be what the SEC wants.
Bloomberg
