Commission-Free Trading Puts Payment for Order Flow Under the Microscope

Discussion in 'Wall St. News' started by ETJ, Nov 15, 2019.

  1. ETJ

    ETJ

    November 14, 2019

    Commission-Free Trading Puts Payment for Order Flow Under the Microscope
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    Julie Evans

    MagnifyMoney

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    Recent moves to commission-free investments by heavy-hitting retail brokers, including Fidelity and Charles Schwab, have payment for order flow under the microscope more than ever, and people are questioning how the two will affect one another. With the loss of commission, will brokers attempt to make up for those lost funds through increased payment for order flow? The answer is murky at best.

    Payment for order flow has always been a controversial practice. Recent moves to commission-free investments by heavy-hitting brokers, including Fidelity and Charles Schwab, however, have payment for order flow under the microscope more than ever, and people are questioning how the two will affect one another.

    What is payment for order flow?

    On the surface, payment for order flow in the investment arena works much like any other industry in which there’s a middleman or broker between a client and the entity with whom the client is doing business. In the case of investments, it’s the third-party “market makers” that serve as middlemen, linking buyers and sellers. When a client places an order to buy or sell stock with a broker, the broker can filter the order to a market maker, which may be able to get better terms when fulfilling it. In exchange, market makers offer payment to brokers for their business.


    The payments aren’t uniform across the industry, though, and some market makers may offer a higher price to brokers for their orders. The concern is that brokers may then choose to do business with the market makers that offer the highest price rather than those that may get the best execution on the end clients’ orders. There’s a potential conflict between what’s right for the brokers’ clients and their own profits.

    [Related: “On the Cost of ‘Free’ Trades”]

    This has always been a potential risk of payment for order flow, but the move to zero-commission trading by many large brokerages, including Fidelity Investments, Charles Schwab, E*Trade and TD Ameritrade, has many wondering if that risk is rising. With the loss of commission, will brokers attempt to make up for those lost funds through payment for order flow? The answer is murky at best.

    How will changes to the investment landscape change the practice?

    How the moves to commission-free trading will affect payment for order flow and the market in general remains to be seen.

    The worry is that brokers will make up for lost income with pay for order flow moves that are in their best interests rather than in their clients’ best interests, and that’s a legitimate worry. However, the fact is that brokers are savvy, and there are multiple ways they can make up for this lost revenue. We may see them add more fees elsewhere, offer more value-add services or perhaps move people to more managed accounts that charge a percentage of assets. Not only that, but there are also regulations, and brokers are held to the standard of best execution.

    When Fidelity announced its move to zero-commission trading, it made it clear that it won’t accept payment for order flow. Fidelity set a most magnanimous example with this very customer-centric move. It’s a big gesture for the company to take a hit to profits to do right by the customer, though there’s likely a bit of market-share play at work as well. It will be interesting to see how and if other companies follow suit.

    We can’t look too far into the crystal ball to predict what’s to come; the best we can do is carefully watch the press releases, earnings and monthly reports of the large brokers that show the number of orders and how they’re profiting from order flow. The good news is that the financial industry is quite transparent, and information is plentiful, even though the relationship between brokers and regulations can be tenuous.

    [Related: “Schwab and Others Confirm Status as Casinos, Purveyors of Financial Opioids”]

    As for robo-advisors and how they will fare in this new commission-free trading arena, it really doesn’t take away from their value proposition. Many people use them if they’re new to investing or are OK paying a management fee (which, as of November 2019, can range from zero to 0.40%) for the convenience of having someone else invest for them. Perhaps free trading will entice a few more folks to start investing themselves, but it’s not likely to have a significant impact, since the decision to use a robo-advisor or invest yourself usually comes down to a matter of time and desire rather than a trading fee.

    Pros and cons of payment for order flow

    Payment for order flow isn’t necessarily a bad practice. There are just some potential pitfalls that raise questions.

    Pros:

    There is certainly an argument to be made that market makers are important to the industry. They provide liquidity in the market, making sure there are enough buyers and sellers at any given time to execute the trades people want to execute. The payments to brokers are a way for the market makers to attract orders and compete.

    Cons:

    The biggest downside to payment for order flow is that it could potentially interfere with customers getting the best deals possible. It doesn’t necessarily lead to abuse, but it creates the opportunity for it. Pay for order flow is banned in Canada, and it is under review in the UK.

    Final thoughts

    Will investors ultimately pay in some way for commission-free trading? Perhaps; but overall, the move to zero-dollar fees is a win for most investors. Whether payment for order flow will become more of a complicating factor, however, remains to be seen. Hopefully, the industry’s regulations and standards will keep investors’ best interests at the forefront of all broker decisions. But the potential for abuse is there, and it’s certainly an area that deserves continued scrutiny and ongoing evaluation.

    TabbFORUM is an open community that provides a platform for capital markets professionals to share their ideas and thought leadership with their peers. The views and opinions expressed are solely those of the author(s). They do not necessarily reflect the opinions of TABB Group, its analysts, TabbFORUM and its editors, or their employees, affiliates and partners.
     
    murray t turtle likes this.
  2. After seeing for years how MM bucketshops like Oanda, forex.com etc ruined the retail spot forex, it is sad to see MM leeches creeping in on equities.

    I would not be surprise if in the near future I see the MM model driving all serious brokers out of business and ruining the retail business just like they did on Forex.

    They are stupid parasites which end up killing the host!!
     
    dealmaker and comagnum like this.