The top U.S. securities regulator on Wednesday proposed rule changes to change how Wall Street handles retail stock trades, but what does that mean for markets and retail traders?
Adam Nasli, head analyst at international broker comparison site BrokerChooser shared his thoughts on the SEC’s plan to overhaul the U.S. market structure and how it will affect retail trading:
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“On Wednesday, Gary Gensler announced the SEC’s plans to change the structure of the U.S. equities market. Some of the key issues Gensler featured were the unequal playing field among players, instances of conflict of interest , and the lack of transparency.
Some of the most important steps Gensler indicated will affect the payment for order flow (PFOF) model, the execution of orders, and pricing of premises.
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How Changes Will Affect Retail Trading
Currently, brokers route most retail orders to off-exchange areas (see Table 1. below), to market makers such as Citadel or Virtu. If the corresponding tick size and competition respectively are introduced and the national best bid (NBBO) is updated, the race between on-exchange (public exchanges such as the NYSE) and off- exchange (wholesalers, such as Citadel or Virtu) areas will be more restrictive and a larger portion of the order flow will likely go to public exchanges.
Based on BrokerChooser analysis, major wholesalers (Citadel, Virtu, G1X and Two Sigma) contributed $ 6.1 billion in price improvements in 2020 and 2021 combined. Price improvement means the price between the implemented price and the NBBO. The expected effect of the new regulatory change is that steeper competition will result in further price improvements.
Changes in the business model of brokers will also be greatly affected, especially those who rely heavily on PFOF profits. In 2021, 77% of Robinhood’s total revenue will come from PFOF, while this number is only 11% in the case of Charles Schwab-TD Ameritrade. Merrill Edge or Fidelity is among the brokers that do not earn PFOF income from stock trading (only from options due to the particular market structure in that segment). Maintaining a commission -free business model for brokers who rely heavily on PFOF profits is a difficult battle.
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An Overview Of Payment For Order Flow
Many U.S. brokers, including household names like Robinhood or TD Ameritrade, provide no commission trading for U.S. customers and earn their revenue from the PFOF model. PFOF is a practice where brokers are paid by market makers, such as Citadel or Virtu, for selling customer order flows. Based on BrokerChooser’s analysis, the following brokers earned the most value from PFOF in 2020-2021:
Table 1.
| Broker name | PFOF earned from stocks and options
(in USD million) |
Execution area % of undirected orders of S&P 500 stocks* | Number of clients by the end of 2022 Q1
(in millions) |
| 1. TD Ameritrade | $ 994 | Off-exchange: 98%
On-exchange: 0% |
33.6 ** |
| 2. Robinhood | $ 532 | Off-exchange: 100%
On-exchange: 0% |
22.8 |
| 3. E*TRADE | $ 316 | Off-exchange: 92%
On-exchange: 8% |
7.6 |
| 4. Charles Schwab | $ 222 | Off-exchange: 99%
On-exchange: 1% |
33.6 ** |
| 5. Webull | $ 118 | Off-exchange: 95%
On-exchange: 1% |
NA |
*Undirected orders are orders when the customer does not specify the place of execution. Most brokers route these orders to market makers. Percentages may not add up to 100% in some cases because the data only covers undirected orders, i.e., when customers do not specify the place of execution.
** Charles Scrwhab and TD Ameritrade merged in 2021.
Customers should know that trading without a commission does not equal zero cost. US brokers that rely on PFOF offer fewer price improvements to their customers. Here, at BrokerChooser, we consider this missed price improvement as an implicit cost because customers typically do better if they choose a broker that does not rely on PFOF (e.g. Fidelity or Merrill Edge) over a brokerage. relying on it (e.g. Robinhood or TD Ameritrade).
The overhaul of the market structure, resulting in more intense competition between off and on-exchange venues, as well as potential changes affecting the conflict of interest inherent in the PFOF model is highly affect brokers who draw large amounts from this revenue stream.
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Proposed Changes To Be The Playing Field Between Off-Exchange and On-Exchange Venues
On-exchange venues, such as the NYSE, can price assets at a penny increase while off-exchange venues offer sub-penny pricing. The SEC plans to adjust tick sizes between on and off exchange venues. This is a change that was also proposed by Kenneth Griffin, founder and CEO of Citadel (one of the market’s biggest markers) at the GameStop hearing last year.
Another important change is the introduction of open and transparent auctions for orders to enhance order-by-order competition. Order-by-order competition means that retail orders will interact directly with institutional orders, which currently does not occur because most retail orders are conducted in off-exchange areas, while institutional orders are usually executed in on-exchange premises.
Finally, the SEC plans to improve the NBBO reference price calculation. For example, odd lots (orders of less than 100 shares) are not included in the NBBO. This will be a great change and the new NBBO will better reflect market conditions as most retail customers are likely to submit exotic lots.
Because of the above, the SEC expects competition to increase and retail traders will have access to better prices. ”
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