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The Robinhood GameStop Listening to will study how brokerage charges are paid on trades

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Thursday's Congressional hearings focused on Robinhood, GameStop, and retailers. The focus is on trading volume, as is the practice of "paying for the flow of orders".

Talk about a comeback story.

A year ago retailers were a declining part of the retail world. Then Covid struck.

Millions stayed at home and got stimulus checks. They went online. With the sport largely closed, this was the first time many took up trading in retail stocks.

According to Piper Sandler, the share of retail trade averaged 13% of the total trade volume in December 2019. By the end of December 2020, this number had almost doubled to 22.8%.

And these retailers have more than their fair share of the trade.

"Not only did the retail share of the trade go up, but they also increased the volume significantly," said Rich Repetto, who follows the trade at Piper Sandler. Total trade in 2020 increased 55% from 2019, as Repetto found. Much of it was driven by retailers.

And the trend will continue until 2021. Average daily share volume has been 42% above 2020 since the start of the year, although Repetto noted that volume in the first quarter is typically higher than the rest of the year.

This is how the payment for the order flow works

This rise in retail has led to increased scrutiny of a practice known as "paying for the flow of orders" in which some brokers receive payments from market makers (traders) to direct business to them.

Most of the retail trade is not done on exchanges, but by market makers who "internalize" the business.

Here's how it works. Say you want to buy 100 shares of Tesla. When you press the button on a trade, you have placed your broker in an order to buy 100 Tesla shares at market price.

Your broker usually has an agreed upon agreement with market makers who compete for the flow of orders. Major market makers include Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma, and UBS.

Doug Cifu, CEO of Virtu, said his company is competing fiercely for this flow of orders: "Most brokers have a 'routing wheel' and within that wheel they will send client orders to the market makers based on the extent the price improvement that they have provided, "he said.

The payment rate for the order flow varies from broker to broker, as Cifu noted, but is usually fixed within the broker. For example, a broker might charge 10 cents per 100 shares. Others may ask for more, others nothing.

According to Cifu, the crucial point is that Virtu and the other companies must meet the best execution obligations, which usually include a price improvement.

Let's go back to that Tesla trade to buy 100 shares. For example, suppose the bid (what a buyer was willing to pay) was $ 792.80, and the demand (what a seller was willing to sell for) was $ 793.20. The midpoint is at $ 793. Cifu said it was typical to offer some kind of price improvement, maybe $ 792.90.

"It's a risk-free trade," Cifu insisted. "As soon as the price reaches us, we guarantee the broker that he will get the best price." Cifu also found that bid-ask spreads have decreased over the past few decades due to technological innovations, execution speed has improved, and fees have decreased.

Is paying for order flow good business for the retailer?

Still, many market watchers have criticized the payment for the flow of orders, including Better Markets, a nonprofit that aims to promote public interest in the financial markets.

In a paper distributed prior to the Robinhood-GameStop hearings, Better Markets claimed that payment for order flow was widespread and created an inevitable conflict of interest between the retail broker and distributor's duties to seek the best possible execution for their customers, and its duties to shareholders and others to maximize revenue … These execution costs may outweigh the retail investor benefits associated with what is known as "commission-free trading". "

According to Cifu, there is no data to support these claims.

"At least you get the same price you would get if you went to an exchange," he said. "Every single broker is based on price improvements and a commitment to best execution."

A recent study by Bloomberg Intelligence's Larry Tabb and Jackson Gutenplan casts doubts on the idea that paying for the flow of orders puts retail investors at a disadvantage: "The controversial practice of retail brokers selling customer orders to market makers (paying for the flow of orders), Benefit Stock Investors Our analysis showed that Citadel Securities and its colleagues returned $ 3.7 billion to investors in 2020 in the form of price improvements, "the study concluded. "That's almost three times what they paid for that equity flow."

Still, the idea persists that market makers who make money must take it from private investors.

UBS's Art Cashin, the dean of floor traders at NYSE, is also skeptical about paying the flow of orders: "If you pay for my flow of orders, is it the best price for me? What's the benefit? Is it because the trader will act against it? It's the public meeting a trader, it's not like the public meeting the public with an exchange. "

Cashin provides a simple formula to determine if the transaction is worth it: "Is the payment you make for the order flow enough to offset the free commission and get a price improvement? If you think this is the case, should you be familiar with it, it is commission-free. "

Cifu agrees with Cashin's assessment and again insisted that his company compete hard for the best execution possible. "This is a very competitive business," he said.

The NYSE fears a deterioration in pricing

The exchanges have another problem: retail orders being routed to relatively "dark" places like broker-dealers without interacting with public orders from the exchanges.

"The growing interest from retail investors is a welcome development," said Michael Blaugrund, NYSE COO.

"But all of this trading in private dark places means that liquidity is becoming less accessible to institutional investors and the pricing process is deteriorating."

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Katherine Clark