Paying for order flow called healthy

Some Wall Street critics liken the practice to paying kickbacks.

But there is no need to shame the industry into kicking the habit.

A university think tank claims that so-called “payment for order flow” is good for the market.

The Mercatus Center at George Mason University in Arlington, Va., says the practice may cut costs for small investors, according to comments filed with the Securities and Exchange Commission.

“They are saying [it’s] a dangerous thing, so we want to require all types of disclosure that will try to shame marketplace participants into curtailing” or even stopping payment for order flow, says Jerry Ellig, a senior research fellow at the center.

The comments were filed last month in conjunction with an SEC proposal to require disclosure by market centers and traders that pay brokers to get orders.

Brokers would have to reveal quarterly where they route their orders and the business relationships they have with the traders they use. They would also have to compare the quality of execution at the places where they send their orders.

Researchers at the Mercatus Center reviewed academic studies on how paying for orders affects price spreads, commissions and investors.

Mr. Ellig says those studies show that the SEC’s premise that payment for order flow leads to worse prices for investors and less efficient markets “is fundamentally wrong.”

“In some cases the savings on commissions alone more than makes up for the increased spread,” Mr. Ellig claims. Investors “get the savings from the payment for order flow.”

The New York Stock Exchange does not pay brokers to send trades its way, but some regional exchanges, such as the Philadelphia Exchange, pay brokers who direct trades to them. “That money ultimately goes to the retail broker,” Mr. Ellig says.

Retail brokers in turn “will spend that money to try to generate more orders … by lowering commissions, giving their customers free credit cards,” and other things, Mr. Ellig says.

The retail brokerage business is highly competitive, he notes, and “the sky’s the limit in terms of the things retail brokers can do with that money to try to attract that business.”

But Mr. Ellig concedes that larger, better-informed investors may be worse off because of payment-for-order-flow practices.

“A dealer is going to charge a higher price or higher spread, or want more compensation, if they’re dealing with an informed investor,” Mr. Ellig says. “They may know something about where the price is going. If I take the other end of that trade, I take a greater risk that the price may go against me.”

impact on prices

The studies show that sometimes payment for order flow raises price spreads “because the larger investors are paying prices more accurately reflecting the risks of dealing with them,” Mr. Ellig says.

The Philadelphia Stock Exchange organization is “for reasonable disclosure,” says its chairman, Meyer Frucher. But he disagrees that payment for order flow hurts investors.

“In an era where the spreads have narrowed, where customer fees have gone down, no study has shown any adverse affect for payment for order flow,” he explains.

“It allows broker-dealers to lower their costs to the customers by monetizing an asset, which is order flow. As long as the system has best execution and price improvement and full disclosure, what’s the bad thing?” Mr. Frucher says.

The Association for Investment Management and Research, which represents securities analysts and investment managers, disagrees.

Maria J.A. Clark, associate for advocacy at the Charlottesville, Va., organization, says the practice is a problem for investors.

In fact, Ms. Clark says, the problem is grave enough that it cannot be addressed simply by requiring more disclosure of the practice.

“We think they actually ought to look at the structure itself,” she says. “They need to go back a little bit, instead of trying to patch the problem with additional disclosures.”

AIMR wants the SEC to empanel a group of market experts representing different segments of the industry to study how trading systems operate.

Retail investors are not going to be able to understand what information is in front of them and what the implications are, she says. “[What] they’re proposing to disclose doesn’t help one judge the quality of the trade. You need to know the motivations of the trade.”

A portfolio manager may be trying to rebalance a portfolio or gain insight into a situation where it would be necessary to execute a trade quickly, Ms. Clark adds.

In both cases, she says, “that information is not provided.”