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SEC considers changes to payment for order flow in stock market

Yahoo Finance Live’s Brian Cheung breaks down the SEC’s proposal for big changes to the stock market.

Video Transcript

BRAD SMITH: Another major topic that we're following this morning. The SEC proposing major changes to the stock market that could take effect as soon as this fall. This is a year after Chairman Gary Gensler directed the SEC to look into ways that the market could work better for small investors and public companies.

Joining us to discuss what this new plan could look like is Yahoo Finance's Brian Cheung. All right, so B. Cheung, help us walk through this a little bit. I mean, this was really kind of initiated off of some of the trading frenzy that we had seen initiated last year at the time of some of the meme stocks and the run-up that we saw then.

BRIAN CHEUNG: Yeah, so this has to do with what is a model known as payments for order flow. We've done some Yahoo U's on this in the past, a very 2021 story. But just to kind of revisit exactly what it is we're talking about, we're talking about how firms like Robinhood, these large brokerages, really make money. And really, the structure of this kind of begins as such, right?

Someone puts an order in, let's say, to buy a share of Tesla at $100. The brokerage firm, like a Robinhood, a TD Ameritrade, will pass that order on to a wholesale market maker, like a Citadel Securities or a Vertu Financial. Now they can get a price improvement. So if, for example, someone ordered it at $100, if that firm, a Citadel Securities referred to, can find it at, say, $98, they'll take the price improvement, that $2 spread that they make, share that among themselves as their own profits, and then give the rest of it to the brokerage like Robinhood to then either pass on those cost savings to the consumer or to pocket it for themselves. Now, if you take a look at the money--

JULIE HYMAN: Well, two guesses what they're doing there.

BRIAN CHEUNG: They're going to take some of that money for themselves. And we actually have a chart that shows you just how much money they have made off of payment for order flows. And you take a look at the majors. Robinhood, that purple line, you can see the massive surge in 2021 around the meme stock frenzy, where you saw all of these types of brokerages, which, by the way, at that time, slashed, essentially, trading fees to zero. They made a lot of money. These are actually monthly figures that you're looking at.

Now, whether or not the change which the SEC is proposing, which I haven't even walked you through, essentially, what the proposal would be as reported-- we haven't seen anything official yet-- it will require those types of wholesale market makers, like Citadel or Vertu, to compete amongst themselves for individual orders, which they're not doing right now.

That is something that the SEC says would bring a little bit more fairness into this space because, as you imagine, this type of scheme involves a lot of kickbacks, right? Robinhood might be incentivized to go to, let's say, for example, one wholesaler over the other because they're getting more money from them in the price improvement. So if there is competition among them, as the SEC is proposing, maybe that would make a little bit more fair of a space there.

BRIAN SOZZI: One aftershock here, Brian-- and this is something that Isaac Boltansky at BTIG noted in a note this morning-- this could-- if there is changes, if that auction process does come to pass, you can see perhaps the end of zero dollar trading commissions.

BRIAN CHEUNG: Not necessarily true.

BRIAN SOZZI: Or trading, just trading--

BRIAN CHEUNG: Right, well, the thing is that it's not necessarily as binary as if the SEC were to require wholesalers to compete against each other, that this would essentially kill the payment for order flow model. Actually, it's weird because you heard Gary Gensler in previous remarks last year say, well, it's not completely off the table that we would ban this whole thing entirely. That would require the $0 commissions to no longer be part of the model. But as proposed, this would actually keep payments for order flow in place.

Essentially, what it would do is perhaps make it a little bit more difficult to get a relationship between the wholesaler and the brokerage because the brokerage can just say, look, I'm just going to go to the wholesale right now. That's going to give me the most amount of money. If the wholesalers have to compete against each other, that actually adds another step to every single order that's being placed. Does that change volume? I can't really say for sure. And that's really what payments for order flow is all about. The more volume you get, the more money you're going to get.

JULIE HYMAN: This feels like a solution in search of a problem. In other words, retail traders have voted with their business. They have flooded the likes of Robin-- right, in other words, where is the complaint coming from, from this? Is it just Gary Gensler that has an issue with this?

BRIAN CHEUNG: No, well, what I think we were talking about here is all of the conspiracy theories that really kind of bubbled up during the meme stock frenzy because it is, indeed, true that for the longest amount of time, retail investors weren't all that knowledgeable about exactly how their brokerages were making money, because when there were commission fees, it was pretty easy. You paid TD Ameritrade X amount of dollars for every trade that you do. They pocket that money. They go to the exchange. They make that order.

But ever since the kind of existence or the growth, rather, of these types of wholesalers who have really marketed themselves as, well, aren't we doing a good thing? We're getting price improvement on these trades, right? But again, just because it's zero dollars doesn't mean it's free. What's happening is that these types of wholesalers are making executions at better trades, better prices than the person who's actually putting in the order had asked for. But it's not really the investor that's going to get all-- they might get some, but they're not going to get all of that price improvement.

So what Gary Gensler's trying to do here is preserve the price improvement aspect of this model, but try to add a little bit more fairness in the space, where it's not necessarily backdoor dealings, where, hey, you have one brokerage that's really only going to one wholesaler because they're just getting the best they'll--

BRIAN SOZZI: When I hear fairness, Brian, I hear Robinhood potentially makes less money.

BRIAN CHEUNG: Again, it's not so clear. What it's really all about I feel like for payments for order flow, as long as the model is still in place, which, again, as reported, appears to be the case, it's all about volume. So when you see that decline in that chart that we showed you in payments for order flow model, that's not because of any other factor beyond how many people are actually doing transactions on those platforms. That's really the bigger macro story. I think if there were to be a change as proposed implemented-- again, we'll find out maybe as soon as tomorrow-- that would actually probably keep this revenue model in place. It's really not for me to say if it's going to go up or down.

JULIE HYMAN: Well, we're going to keep talking about it, that's for sure, considering how interested we all are in this and retail traders are, too. Thank you, Brian. Appreciate it.