The GameStop (GME) story has fueled interest in the once-arcane process known as payments for order flow, an industry practice that exploded in 2020 amid the retail investor frenzy over the stock market.
Data from Alphacution shows that revenues from payments for order flow almost tripled at the four major brokerages — TD Ameritrade, Robinhood, E*Trade (MS), Charles Schwab (SCHW) — to $2.5 billion in 2020 from $892 million in 2019. Other brokerages, including Webull, Ally Invest, and Interactive Brokers accounted for another almost $300 million in payments.
Alphacution further notes that 60.9% of the payments for order flow were made on options. Among wholesalers, 41.7% of payments for order flow in 2020 were paid by Citadel Securities.
The surge in payments for order flow coincided with the brokerage industry’s departure from a commission-based model, which used to charge clients a fee for making trades. But Robinhood disrupted the industry by abandoning the model entirely and eliminating fees, opting to rely instead on payments for order flow to make money.
Other brokerages followed, and a race for scale triggered a number of blockbuster mergers beginning in 2019.
“Payment for order flow helps cover the costs of running our business and offering commission-free trading to customers,” Robinhood CEO Vlad Tenev told the House Financial Services Committee during a hearing about the GameStop incident on Thursday.
What is payments for order flow?
In a payments for order flow model, a brokerage processes orders from investors and passes them on to a wholesaler, like Citadel Securities or Virtu Americas. These market makers then execute the purchase or sale of a stock at publicly quoted prices, in turn paying brokerage firms for routing the trade through them.
The profit-sharing of this scheme is built into the bid-ask spread.
In a trade, a client gives the brokerage firm an ask price, or how much they’re willing to pay for a security. The price that the wholesaler is able to locate and execute on is called the bid spread.
If the wholesaler is able to purchase the stock at a lower price than the client asked for, the bid-ask spread serves as a bounty split by the brokerage and the wholesaler.
A wholesaler pockets some of that spread for its work in finding the better price, and the remainder is paid out to the brokerage for passing along the order to the wholesaler in the first place (hence, “payments for order flow”).
The brokerage can do a few things with this payment: It can pass along some of the savings to the investor (reflected as purchasing the stock at below ask price), or it can pocket the savings within the company.
Need for reform?
The infrastructure around payments for order flow has raised questions about the relationship between wholesalers and the brokerages, illustrating the structural costs of a commission-free model.
The Securities and Exchange Commission (SEC) requires brokers to disclose information about how they handle client orders, through rule 606.
But probes from members of Congress suggest that there could be interest in some sort of legislation.
Citadel Securities, the market maker subsidiary of Citadel LLC, told Congress that the existing model has saved retail investors billions of dollars, adding that the company prioritizes execution quality. But Citadel LLC CEO Ken Griffin said that it could adapt to any changes.
“Payment for order flow has been expressly approved by the SEC,” Griffin told the House Financial Services Committee Thursday. “It is a customary practice within the industry. If they choose to change the rules of the road, we need to drive on the left side versus the right side, that’s fine with us.”
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.