Brokers look to replace payment for order flow amid SEC crackdown

The brokerage industry is exploring alternatives to payment for order flow as SEC chair Gary Gensler takes aim at the practice.

One idea is coming from Apex Clearing, CNBC has learned. The clearing firm handles trades for SoFi, Webull and other fintechs and has been quietly building a marketplace for matching customer orders. The “auction” process, as the Apex CEO describes it, could let stock exchanges compete directly with market makers like Citadel Securities and Virtu.

“It creates more competition, which will translate into better prices,” Bill Capuzzi, CEO of Apex, told CNBC. “The big winner is the retail investor.”‘

Earlier this week, SEC chairman Gary Gensler proposed changing rules that govern how Wall Street handles retail trades. The top securities regulator said his plan would, in part, require firms to compete directly to execute trades from retail investors. Gensler is also looking for more disclosures around fees and data. The SEC chair has been critical of potential conflicts of interest and complained of power being concentrated among select market makers.

“I asked staff to take a holistic, cross-market view of how we could update our rules and drive greater efficiencies in our equity markets, particularly for retail investors,” Gensler said at a Piper Sandler fintech conference on Wednesday.

Payment for order flow, or PFOF, refers to payments brokerages receive for directing customer trades to a market maker, such as Citdel or Virtu. While it’s often a fraction of a penny, the arrangement brings in the bulk of revenue for Robinhood and other brokerages, and has allowed them to offer commission-free trading.

PFOF is widely practiced by the brokerage industry but came under fire during the Gamestop saga. Gensler and the SEC questioned potential conflicts of interest and whether retail traders were getting the best price. Companies are already required to give customers the best price, known as “best execution.”

While the marketplace — technically called an alternative trading system — is “built and ready to go,” Apex’s Capuzzi said, it has yet to launch and could require SEC approval. But if approved, an auction like this may pre-emptively solve some of the agency’s complaints about how the securities industry operates behind the scenes.

Rich Repetto, a managing director and senior research analyst at Piper Sandler, said there could be more examples of firms trying to test ideas ahead of any formal SEC moves. That may even reduce the need for any changes to the current rules.

“Now that the outline was presented by Gensler, there could be innovation in front of it that could get him to where he wants to be without any formal rulemaking,” Repetto told CNBC.

While still a variation of payment for order flow, a marketplace like the one Apex is building may shrink the profits for wholesale market makers, Repetto said.

Another alternative to Gensler’s proposals could be the industry moving back to “internalization,” or brokers filling customer orders from a firm’s own inventory, according to Devin Ryan of JMP Securities. The practice is only an option for larger self-clearing brokerages with significant order flow. Fidelity does this, for example. Charles Schwab and E*Trade used to.

“This scenario could even be more economic for the largest players but would likely lead to more fragmentation in liquidity and more questions on execution quality,” Ryan said.

Robinhood’s chief legal officer Dan Gallagher, a former SEC commissioner, argued that as things stand retail traders have never had it so good. Gallagher pointed to fast execution, zero commissions and zero account minimums as reasons to keep the status quo.

“It is a really good climate for retail. To go in and muck with it right now, to me, is a little worrisome,” Gallagher said at the same industry conference Wednesday.

For traders though, an auction set-up with more competition could result in incrementally better prices. While it might look “miniscule,” around 1 cent for some trades, it eventually adds up, Capuzzi argued.

“If you do this over and over again, and you’re giving a 10% better execution, that goes back to the retail trader — it’s better execution on both the buy and sell side, so more money in their pockets,” Capuzzi said. “This can make a material impact and change to the positive for the market structure.”

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