Simon's Prediction for 2022: The US Officially Bans Payment for Order Flow - 7investing 7investing

Simon’s Prediction for 2022: The US Officially Bans Payment for Order Flow

2022 is the year that the US needs to put an end to PFOF once and for all.

January 22, 2022

The writing’s been on the wall for quite awhile, and I think this is the year we take action. My prediction is that the Securities and Exchange Commission will officially ban Payment for Order Flow in 2022.

Payment for Order Flow refers to when equity brokerages (like Schwab or Robinhood) send their orders to middlemen (often called wholesalers or high frequency traders/HFTs) for execution, rather than having them fulfilled directly by the exchanges (like the NYSE or Nasdaq). The HFTs hold an inventory of shares (or options contracts) and charge a spread between the bid and ask price. They then pay a cut of each transaction fulfilled back to the brokerages.

And we aren’t talking small potatoes here. Last year, it was estimated that 47% of all US retail trading volume was executed solely by one firm — Citadel Securities — who is America’s largest trading wholesaler.

Brokerages who support the practice claim it allows them to avoid charging commissions, and that retail investors benefit from paying fewer fees.

But there is no free lunch. The prices that retail investors are paying for the orders fulfilled by the HFTs don’t always match those displayed by the stock exchanges. Furthermore, the HFTs are collecting massive amounts of trading and pricing data that allow them to front-run the broader markets, who don’t see that data until later on. This leads to the less-transparent “dark pools” of capital, which are the same market-making practices that eventually made Bernie Madoff notorious.

While Payment for Order Flow isn’t yet illegal, it’s extremely controversial. 7investing subscribers already know I despise it. And in fact, the practice was banned entirely in the United Kingdom in 2012, whose regulators argued that HFTs were creating a “less efficient and less competitive” environment for retail investors. The CFA Institute wrote a paper two years later that further supported that decision.

And that’s not to mention the “gamification” of the stock market that many brokerages like Robinhood are now promoting. Robinhood makes more money by collecting more PFOF checks that come from greater trading volume. So in its own self-interests, it is encouraging its user base to jump in-and-out of stocks on a continual basis. (As a long-term, buy-and-hold investor, this gamification of the system makes me livid.)

The US needs to take a stand and ban PFOF from its public equity markets. SEC Chairman Gary Gensler has already provided testimony that showcases his displeasure. The SEC has recently taken action against Robinhood to ensure it is prioritizing customer price improvement over PFOF. It also approved a proposal from the Chicago Board Options Exchange that allowed ad hoc stock auctions (i.e. batch trades that happen at discrete moments in time) as an alternative to continuous trading.

I think that means the stars are aligning and Payment for Order flow gets the axe in 2022. It’s the right thing to do, and I believe it will ultimately be a benefit for investors.

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