The recent debate about the execution service on the GameStop stock has brought to the fore the question of “payment for order flow”. We believe these practices create conflicts of interest, to the detriment of retail investors.
A new generation of millennials started trading shares during the Covid-19 crisis. They are more exchange-savvy and have adopted sophisticated trading strategies. The GameStop case demonstrated that these investors’ new investment tactics could interfere with the interests of certain hedge funds and other market participants. Many end investors have complained about some US brokers’ decision to restrict their execution service on the GameStop stock.
Bilateral agreements between brokers and market makers are common practice in the US. The retail broker will execute the client’s order through or against a single market maker. In return, the broker may receive financial compensation while their clients get better pricing than is available in the public markets. Such renumeration is known as “Payment for Order Flow”. We believe this system creates conflicts of interest for the brokers and is ultimately detrimental to retail investors.
Paying to receive clients’ orders in the US
Market makers compete for retail brokers to send them retail investors’ order flow. Once an order is routed to a market maker, it is handled according to strict best execution rules: specifically, it must be filled at, or better than, the NBBO (National Best Bid and Offer). However, when there is a general agreement to route order flow to a market maker, there is no competition from other market participants on the execution price for that particular order. In most cases orders are executed against the account of the market maker at better prices than NBBO rather than being sent to transparent, multilateral venues that could potentially provide even better prices.
In addition, in the US, exchange quoting increments are constrained to a minimum level of a penny. Some believe that active stocks should be allowed to quote in finer increments such as half pennies, and that this “constraint” causes flows to trade away from the public markets.
Could this happen in Europe?
Even though European regulators have implemented rules to limit payment for order flow and conflicts of interest, this practice does exist in Europe. While they are not allowed to directly remunerate brokers, trading platforms can act as intermediaries to enable this practice. Brokers and market makers can deal together, with an execution that is favourable to the market maker. In return, the trading platform receives financial compensation from the market maker, and the execution service on the trading platform may be free of charge for the retail broker.
Euronext’s Quantitative Research department conducted a study on the alternative trading platform that is most used by retail brokers in Europe. It confirmed that its model goes against the interests of retail investors.
A US broker has to communicate on the remuneration it receives from a market maker. But European brokers do not have to inform their clients that the trading platform to which they send their clients’ orders has exempted them from any execution fees.
At Euronext, we believe it is essential to inform retail investors about how payment for order flow can impact the execution quality and price. In January 2021, the AMF published a guide for retail investors explaining how they can know whether or not a broker sends their orders to an exchange: amf-france.org.
Read our Quant Research report “Best of Book versus Apex: no free lunch – trading on Apex more costly than on Best of Book.