Yahoo Finance’s Brian Cheung joins the Yahoo Finance Live panel with the today’s Yahoo U: Payment for Order Flow.

Video Transcript

ZACK GUZMAN: Welcome back to Yahoo Finance Live. If you watched the House hearing yesterday in the GameStop and Robinhood, you probably heard payment for order flow mentioned a few times, that practice of brokerages selling your trades to market makers like Citadel Securities. Obviously not something that just Robinhood does-- other brokers do it as well. But here with a look at how much money is made off that practice and how it's continuing to grow in the sector, I want to bring on Yahoo Finance's Brian Cheung with a look at that in this week's Yahoo U.

BRIAN CHEUNG: Well, Zack, welcome-- welcome back to class. Class is in session. And again, as you mentioned, yesterday's congressional hearing did really underscore the relationship between brokerages and also wholesalers in any sort of stock trade. But of course, they can get awfully confusing. So let's walk you through exactly how this works with example here.

So let's say, for example, you, Zack, are trying to put in orders for Cheung Shoes, right? This is my company. I sell sneakers. And you're trying to snipe some of these crispy tendies. You know the vibes, right? So you're going to order 100 shares of Cheung Shoes through your brokerages. Now, back in the day, you had to literally call a broker to do this, right? But today, that call is just going on your trading app, your TD Ameritrade, your E-Trade, Robinhood. And you're going to place the order for 100 shares.

Now, in the payments for order flow structure, the broker is going to take the order, and it's going to pass it to a wholesale market maker, Citadel Securities or Virtu Financial. Now these market makers are the specialists at really executing these trades. And they're going to go out on the hunt for Cheung Shoes stock, right? And then they're going to buy the stock at a publicly quoted price on the New York Stock Exchange. So again, three players here-- brokerage firm, the market maker or wholesaler, to the exchange itself.

So where in all of this is the actual payments for order flow? Well, let's take a hot second on that. So when Zack asked to buy shares of Cheung Shoes, he put in the price that he's willing to pay-- so $100, for example. They call this the ask price. But as part of any order, there's also a second price called the bid price. And this is the price that the broker is actually going to have the wholesaler execute the trade on, right? So Zack asked to buy at $100, in other words, but the wholesaler found it that $98, right? That's a good thing.

Now what happens with the $2 of the bid ask spread between these two prices? Well, the wholesaler, right, the Citadel or-- Citadel Securities or Virtu Financial could say, I'm going to pocket $1 of it kind of as a finder's fee, and then I'm going to take the other dollar and give it back to the brokerage that gave me that order in the first place, right?

So let's say, for example, the brokerage that Zack ordered on takes that dollar. It can do a few things with that. It can take $0.50 of that dollar and then pass it on to Zack and say, look, I actually found you that share at $99.50, and then the brokerage can take the other $0.50 and pocket it for its own operations.

So the metrics show how big of a deal this has become for at least the four major brokerages, which you're looking at here. This is data from Alphacution, the SEC, and also company data. Again, these are the four top brokerages-- TD Ameritrade, Robinhood, E-Trade, and Charles Schwab. You can see, I mean, just between 2019 and 2020, revenue just from this specific business line almost tripled from $892 million to $2.5 billion. And at Robinhood specifically-- take a look at the blue bit here-- 600-- or rather, $69 million in 2019 ballooned to $687 million in 2020. That's about 10-fold in just one year.

And the data is not on this chart, but among all the payments for order flow, which is more than just these four. There's other stock brokerages that are smaller as well. A 41.7% were paid by-- you guessed it-- Citadel Securities. So they are pretty much a giant in that space. And all this, guys, really just illustrates why this is such a hot debate. I mean, this structure is the reason for why zero commissions exist in the first place, but it's also added a middleman, and it's raised questions about the incentive structure, between the brokerages and how they team up with a wholesaler.

But one last thing I want to point out here-- this is really important to keep in mind-- the model that I just showed you does not include any hedge funds. So Citadel Securities is different from Citadel's hedge fund. It's separate. And by the way, it's also illegal to frontrun. There's no frontrunning. There's no jumping any trades when you receive an order flow from a brokerage. That's really important to note as well, especially in the context of GameStop. You didn't even need to have the order flow to see that GameStop stock was going up. So there was really no frontrunning that was needed there.

But all that really important and shows how controversial all this is-- something important for regulators, the industry, and also legislators to keep in mind in the months and the years ahead. Zack, Akiko.

AKIKO FUJITA: Brian Cheung, proving you that you don't need five hours, right, to explain payment for order flow. There was so many questions popped up in the hearing yesterday, but now we know a lot more. And of course, you can read about all of this on our website. Thanks so much for that, Brian.