Markets are a means, not an end. Access to investing, therefore, is a means to achieving an outcome.
The debate around payment for order flow seems to have lost that critical point, centering on whether the increased access to free trading for retail investors is worth the money wholesalers earn to execute their orders. This debate is misguided. Pointing fingers at retail brokers or market makers that turn a profit ignores the more substantive issues plaguing retail investors.
Many people in this country want some version of the same thing: financial security and stability in the future. This need takes every possible shape and form across the socioeconomic spectrum. A fortunate group —
As the SEC considers where to focus its time and energy on this issue, we (as an industry) need to examine retail investors' objectives and the foundations of order flow payments. That provides critical insight into where attention should be paid to actually protect retail investors.
In the history of capital markets, there have always been intermediaries. Wholesalers who pay for order flow are just one of many. However, insofar as the end investor is concerned, the focus should be on whether there's a benefit to using a go-between.
Wholesalers add value to retail investors by producing price improvement for their orders. The investor gets a better price for their order than what they would get from a national exchange. You can certainly have a philosophical debate over who gets the difference. And many argue that all price improvement should go to the investor, and not even a fraction of a penny should go to the retail broker selling order flow.
That's a worthwhile debate, but once investors realize that if they received all of the price improvement available, brokers would need to start charging commissions again, the debate ends. Take the following example: an investor uses a broker that sends orders to a wholesaler to buy 10 shares of Apple. The bid is $150.25, and a wholesaler is offering $150.10. The investor is getting 15 cents of price improvement per share, or a total savings of $1.50. The retail broker that routed the order to the wholesaler also gets a few pennies for that flow. Alternatively, the investor could forgo any price improvement, pay the bid, and send the broker a commission.
Given the history of retail brokers, that commission is almost always going to exceed the price improvement obtained, so the investor winds up paying more. What would an investor rather do? Most reasonable people would opt for a wholesaler with order flow payments to get price improvement and avoid a commission.
Proponents of increased regulations are pushing for a ban on payments and caps on commissions. We could take that approach, but we generally don't demand cost-saving pass-throughs as a regulatory schema. And there's a far better way to solve this: let the market sort out who best takes care of their customers.
Again, if access to investing were the only goal, we'd probably already have a winner in the market. But it isn't. And as a new generation of investors eventually experiences an inevitable bear market, they'll learn that going it alone, not consulting with a professional, and trading on Reddit and TikTok tips isn't how they'll realize their financial goals. When that happens, many investors will find a new home for financial advice — one that's far less concerned with methods and more focused on objectives. The debate on order flow payments will be old news. And we'll probably end up debating fiduciary standards … again.
While wholesalers claim to have delivered over $3.6 billion in price improvements to investors in 2020, they also earned billions of dollars of revenue in the process. And certain retail brokers do a lousy job explaining their process of internalization. So it's natural that this generates some regulatory interest.
But here are some troubling statistics that the SEC doesn't appear to be paying attention to: Only 39% of Americans could afford a $1,000 emergency expense. And 44% of Americans don't own a single stock, ETF or mutual fund. Most of those investors who access the market don't consult with a professional advisor before investing. Of those who use a financial advisor, most are uncertain if their advisor is a fiduciary or not.
There are significant problems preventing investors from achieving better outcomes. Unfortunately, restructuring how brokers internalize orders and use wholesalers wouldn't even make the top 50 list of priorities that can help bridge that gap. The SEC could do far better to focus on brokers' obligations to their clients, investor education in understanding the fiduciary standard, revisions to Reg BI that apply a useful standard of care to self-directed investing … the list goes on. But we'll first need to return to basic principles, acknowledging that markets are a means, not an end.
Investor outcomes, not investor activity, are where regulators can be most helpful.
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