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Brokers seek to replace payment for order flow amid SEC crackdown


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

An idea comes from Apex Clearing, CNBC has learned. The clearing house handles transactions for SoFi, Webull and other fintechs and has quietly built a marketplace to match customer orders. The “auction” process, as the Apex CEO describes it, could allow exchanges to directly compete with market makers like Citadel Securities and Virtu.

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

Earlier this week, SEC Chairman Gary Gensler proposed changing the rules that govern how Wall Street handles retail transactions. The top securities regulator said its plan would, in part, force firms to compete directly to execute trades for retail investors. Gensler is also looking for more disclosures regarding fees and data. The SEC chairman criticized potential conflicts of interest and complained about the concentration of power among some market makers.

“I asked staff to take a holistic, cross-market view of how we could update our rules and make our stock markets more efficient, especially 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 client trades to a market maker, such as Citdel or Virtu. Although often a fraction of a penny, the arrangement generates the bulk of revenue for Robinhood and other brokerages, and has allowed them to offer commission-free trades.

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

While the market — technically called an alternative trading system — is “built and ready to go,” Apex’s Capuzzi said, it hasn’t launched yet and may require SEC approval. But if approved, an auction like this could preemptively resolve some of the agency’s complaints about the workings of the securities industry behind the scenes.

Rich Repetto, managing director and principal research analyst at Piper Sandler, said there may be more examples of companies trying to test ideas ahead of any formal SEC rulings. It may even reduce the need to modify the current rules.

“Now that the plan has been presented by Gensler, there could be an innovation ahead of him that could get him where he wants to be without any formal regulations,” Repetto told CNBC.

While still a pay-for-order-flow variant, a marketplace like the one Apex is building can reduce profits for wholesale market makers, Repetto said.

According to Devin Ryan of JMP Securities, another alternative to Gensler’s proposals could be for the industry to return to “insourcing” or for brokers to fill customer orders from a company’s own inventory. The practice is only an option for large self-clearing brokerages with significant order flow. Fidelity does, for example. Charles Schwab and E*Trade were used to it.

“This scenario might even be more economical for larger players, but would likely lead to more liquidity fragmentation and more questions about execution quality,” Ryan said.

Robinhood chief legal officer Dan Gallagher, a former SEC commissioner, argued that as things stand, retail traders have never been better. Gallagher pointed to fast execution, no commission and no account minimums as reasons for maintaining the status quo.

“It’s a really good climate for retail. For me to go in there and get involved right now is a little worrying,” Gallagher said at the same industry conference on Wednesday.

For traders however, setting up auctions with more competition could result in progressively better prices. While that might seem “tiny,” about 1 cent for some trades, it does add up, Capuzzi argued.

“If you do this over and over again, and you deliver 10% better execution, that comes back to the retail trader – that’s better execution on both the buy and sell side, so more ‘money in their pockets,’ Capuzzi said. “It can have a big impact and positively change the structure of the market.”

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