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Brokers look to interchange 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 on 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 constructing a marketplace for matching customer orders. The “auction” process, because the Apex CEO describes it, could let stock exchanges compete directly with market makers like Citadel Securities and Virtu.

“It creates more competition, which is able to translate into higher prices,” Bill Capuzzi, CEO of Apex, told CNBC. “The large winner is the retail investor.”‘

Earlier this week, SEC chairman Gary Gensler proposed changing rules that govern how Wall Street handles retail trades. The highest securities regulator said his plan would, partly, require firms to compete on to execute trades from retail investors. Gensler can also be on the lookout for more disclosures around fees and data. The SEC chair has been critical of potential conflicts of interest and complained of power being concentrated amongst 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 guiding customer trades to a market maker, similar to Citadel Securities or Virtu. While it’s often a fraction of a penny, the arrangement brings in the majority of revenue for Robinhood and other brokerages, and has allowed them to supply commission-free trading.

PFOF is widely practiced by the brokerage industry but got here under fire through the Gamestop saga. Gensler and the SEC questioned potential conflicts of interest and whether retail traders were getting the perfect price. Firms are already required to provide customers the perfect price, referred to as “best execution.”

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

Wealthy Repetto, a managing director and senior research analyst at Piper Sandler, said there may very well be more examples of firms attempting to test ideas ahead of any formal SEC moves. That will even reduce the necessity for any changes to the present rules.

“Now that the outline was presented by Gensler, there may very well be innovation in front of it that would get him to where he desires to be with none formal rulemaking,” Repetto told CNBC.

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

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

“This scenario could even be more economic for the biggest players but would likely result in 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 0 account minimums as reasons to maintain the establishment.

“It’s a very good climate for retail. To go in and muck with it right away, to me, is somewhat worrisome,” Gallagher said at the identical industry conference Wednesday.

For traders though, an auction set-up with more competition could lead to incrementally higher prices. While it would look “miniscule,” around 1 cent for some trades, it will definitely adds up, Capuzzi argued.

“If you happen to do that over and another time, and also you’re giving a ten% higher execution, that goes back to the retail trader — it’s higher execution on each the buy and sell side, so extra money of their pockets,” Capuzzi said. “This may make a cloth impact and alter to the positive for the market structure.”

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