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Securities and Exchange Commission Chairman Gary Gensler got the attention of investors this week when he said that banning payment for order flow was an option “on the table” — but experts tell MarketWatch that it’s unlikely the regulator will take such a drastic step.
In an interview with Barron’s, the SEC chief said the practice of payment for order flow — whereby stock brokers sell the privilege of fulfilling retail orders to market makers in return for a share of profits — results in “an inherent conflict of interest.” He noted that the U.K., Australia and Canada have all banned the practice and that a U.S. ban could be in the cards as well.
The news sent shares of app-based broker Robinhood Markets Inc.
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down 6.9% on Monday, while those of rival Charles Schwab Corp.
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fell 3.2%. Though Robinhood’s stock has clawed back some of those losses, it still remains down more than 4% on the week, according to FactSet. Robinhood earns the vast majority of its revenue from payment for order flow.
Michael Piwowar, former acting chairman of the SEC and now executive director of the Milken Institute Center for Financial Markets, told MarketWatch that Gensler’s comments are in line with previous statements on the issue and that SEC policy requires regular reevaluation of most regulations.
“I was not surprised that Chairman Gensler said that all options are on the table — that’s just part of standard practice at the commission,” he said. “In general, on all policy issues the SEC is constantly looking at whether or not their current rule set fits the current market conditions.”
Piwowar added that it’s especially important that the SEC continuously evaluates market structure issues like payment for order flow, because practices and technology are changing so quickly. For instance, the emergence of zero-commission trading platforms is a new phenomenon, and it would only make sense for the SEC to reconsider its rules given this new reality, he said.
Before the SEC could institute a ban of the practice, federal law requires that it engage in a lengthy public debate and produce an exhaustive cost-benefit analysis. On the issue of payment for order flow, a rule proposal would have to include an empirical analysis of all the reasonable policy options, ranging for the status quo to an outright ban.
After this analysis, the five-member commission could vote on a rule proposal, which would be followed by a monthslong public comment period that the SEC would be required to take into account before issuing a final rule.
Even if the SEC would vote to adopt a ban on payment for order flow, parties harmed by the decision could sue the agency in federal court if they believe it has overstepped its authority or has not adequately evaluated the costs and benefits of the proposal.
“There’s a whole regulatory process that can take anywhere from one to two years to actually move forward on something, and it would require the other commissioners to weigh in along with staff,” Piwowar said.
It’s not clear that the other four SEC commissioners are enthusiastic about changing the rules around payment for order flow, let alone banning the practice altogether. Gensler’s fellow Democrats on the committee have made public statements suggesting they agree there is a need to study the issue. The commission’s two Republicans, however, have stressed that trading costs for retail investors have fallen precipitously in recent years and that any rule changes should take that into account.
Commissioner Hester Peirce, a Republican, said in February that she believes on balance, payment for order flow has “likely has benefitted retail investors, as it has reduced the cost of making a trade.” She acknowledged that the practice has inherent conflicts of interest but that the solution is more and better disclosure of payments between market makers and brokers.
“An outright ban is probably not the most likely outcome here,” Ken Joseph, a former SEC enforcement and examinations official and regulatory consultant at Kroll, told MarketWatch. “I foresee a scenario where increased disclosure is the regime and where increased emphasis is going to be placed on making sure brokers fulfill their best execution obligations to their customers.”
Critics of payment for order flow will likely not be satisfied by increased disclosure and beefed up enforcement of rules that require brokers to execute trades at the best available prices. After all, the SEC measures the best price by studying the prices offered on so-called “lit” exchanges like the New York Stock Exchange or the Nasdaq. But retail orders are often not fulfilled on those exchanges and those orders are not used to estimate the official best price, called the National Best Bid Offer.
“The larger issue is around market segmentation,” Joseph said. “Probably only half the orders are done in the lit markets which provide transparency into what the NBBO is. We’re only getting half the picture.”
Forcing all trading into lit exchanges, however, would create its own host of problems, creating a system where large institutional traders who manage pensions and 401(k)s could distort markets when executing large trades, he said.
Piwowar noted that these are complex problems that always involve trade offs, and that this dynamic is reason to believe that the SEC will refrain from taking drastic regulatory steps. Payment for order flow does create a conflict of interest, but under the commission model those conflicts exist as well, because brokers earn more money the more trades a client makes, he said.
“The SEC already recognizes this conflict of interest,” he said. “Many of the SEC’s regulations are explicitly there to mitigate it.”
