Gary Gensler, chair of the U.S. 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, which would be a serious problem for all Americans.
From where I'm standing, 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 PFOF has essentially made that on-ramp free to use - PFOF is a blessing, not a curse.
That's why 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.
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.
In fact, there's a particular firm that's become a poster child for this controversy, because it happens to be a high-frequency trading shop that's also publicly traded. Media sentiment is driving its stock down right now, but it's not going to last, and when the air clears on this misguided ploy, it's going to bounce back in a hurry.
Investors who get in at the right time are in for a nice ride. Here's the situation...
PFOF In a Nutshell
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 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 which 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. Market-makers like Citadel Securities 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 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 fills 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.
So, how can you make money on this political stunt? Easy.
This Retail Trading Giant Is Prepped for a Comeback
Virtu Financial Inc. (NASDAQ: 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, 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.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.