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GameStop Saga Spurs Debate Over Payment for Order Flow Practice | WSJ - YouTube
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(soft tense music)
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- [Reporter] In February,
Congress, grilled executives
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from Robinhood and Citadel Securities
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over their role in the
GameStop trading frenzy.
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And throughout the hearing,
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a phrase came up over and over again.
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- Payment for order flow.
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- Payment for order flow.
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- Payment for order flow.
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- Payment for order flow.
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- With respect to payment for order flow,
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we simply play by the rules of the road.
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- [Reporter] Payment for order flow
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is a decade-old practice
that's at the heart
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of how commission-free brokers operate,
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and it's creating controversy.
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Critics claim that the practice creates
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a conflict of interest
that is bad for investors.
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- While it may enable free
commissions and explicit costs,
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there are implied costs
we feel everyone ignores.
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- [Reporter] But supporters say
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the practice is misunderstood
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and that it's actually good for investors.
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- Whether you're a Robinhood
client or a Fidelity client,
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you're getting a price
that is at or better
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than the national best
bid or best offer, right?
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That's the thing.
- Well, lemme ask-
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- There's nothing nefarious going on here.
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- [Reporter] Following
the GameStop episode,
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the SEC is expected to conduct a review
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that could change the rules
of payment for order flow
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and how brokers operate.
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(soft tense music)
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When an investor buys a stock
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on a commission-free trading app,
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the transaction is
executed almost instantly.
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But a lot is going on behind the scenes.
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Let's take a look at the main players.
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There are buyers,
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the investors who want
to purchase a stock,
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and there are sellers,
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the investors who want to unload a stock.
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There's also the broker,
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the firm that accepts investors' orders
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and make sure they get executed.
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And finally, there are the market makers,
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which buy the orders from
the broker and execute them.
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These are usually high-frequency traders
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like Virtu Financial
and Citadel Securities,
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and they are the players
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that make the trade actually happen.
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- When you're the investor
and you're buying,
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the market maker's selling.
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If you're the investor and you're selling,
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the market maker is buying.
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But the market maker hopes
to do a lot of little trades
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all day long and eventually
arrive at a place
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where they're flat.
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- [Reporter] Zero commission
brokers make money
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by selling customers'
orders to market makers.
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This is payment for order flow.
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The practice enables trades to be executed
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at a high volume very quickly.
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It also means that most orders
entered by small investors
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never get sent to public exchanges
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like the New York Stock
Exchange or NASDAQ.
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Instead, small investors'
orders get executed privately
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by market makers.
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Let's break down how the process works.
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Say an investor wants to
sell 200 shares of a stock,
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so they place an order with a broker.
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The chances that another person
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wants to buy that exact amount of shares
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at the same time is pretty
low, but that's okay
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because the broker routes
the orders to a market maker.
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The market maker fills it
within a fraction of a second,
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but that comes with risk,
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the risk that the price
of the stock could fall
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before the market maker
can sell the 200 shares
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to someone else.
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The market maker is paid
for taking on this risk
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through what is known
as the bid-ask spread.
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You can see it here.
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The spread is the difference in price
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between what buyers are paying for a stock
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and what sellers are selling for it.
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It doesn't usually amount to much.
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On stock exchanges, it's
often just a penny per share.
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When market makers
execute trades privately,
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the spread can be even tighter.
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This is because the prices can
be in fractions of a penny.
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Say, using our example,
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that the spread is just half a cent.
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So buying and selling those 200 shares
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would make the market maker $1.
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But as millions of shares are traded,
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the profits from the spread add up.
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- It's easy money for them.
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The retail investors are small,
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they don't place very large orders,
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and they don't tend to be
extremely well-informed
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about the movements of the stock price.
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- [Reporter] In 2020,
these brokerages collected
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almost $2.6 billion in payments
for stock and option orders.
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And this is part of what's
driving the current controversy
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over the practice.
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Some critics say that
payment for order flow
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creates a conflict of interest
between the broker's duty
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to seek the best execution for trades
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and its desire to
maximize its own profits.
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- In the US, brokers have
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what is called a duty of best execution.
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They have to get you the
best possible execution
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on your trades, or at
least attempt to do so.
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If a broker is taking a lot of money
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in payment for order flow,
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then odds are it's not really
giving you a best execution.
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- [Reporter] Critics say this is because
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brokerages could be tempted
to send customer orders
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to the market centers that
pay them the biggest rebate
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or that brokers could be
demanding greater payments
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from the market makers.
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This is why the practice is banned
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in some other countries like the UK.
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- In other countries
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where payment for order flow is illegal,
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everything has to go to exchanges
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so everything is in the lit markets
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where everybody can see
the prices coming together.
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All the trading happens
kind of out in the open.
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- [Reporter] Some critics
even worry that market makers
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could be front-running
investor stock trades,
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but supporters say these
claims aren't true.
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Brokers and market makers argue
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that payment for order
flow often gives investors
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a better price than the best market price
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and that it helps make trading easier.
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- So payment for order
flow has a very big benefit
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for investors, and that is,
it has allowed the emergence
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of zero commission trading.
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It was just a few years ago
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that brokers were typically
charging 4.95, 7.95 or more
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for a single stock trade.
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A couple of years ago that went away
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Robinhood set the practice,
and then a bunch of others
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like Schwab, TD Ameritrade,
E-Trade following.
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- [Reporter] In the past,
the SEC has approved
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of payment for order flow
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as long as brokers make
certain disclosures,
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like where they're
routing investors' orders
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and how much they're
getting paid for them.
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The agency has said that small investors
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generally get better prices
when their orders are sent
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to market makers rather than exchanges.
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But the volatility in GameStop
is raising alarms in Congress
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where lawmakers are
calling for fresh scrutiny
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of payment for order flow.
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In February, SEC Acting
Chairwoman Allison Heron Lee
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wrote a letter showing
support for a wholesale review
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of the practice.
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- If the review uncovers
any sort of abuses,
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what I think is most
likely going to happen
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is that the SEC will require
some sort of new disclosures
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coming out of brokers and
maybe out of market makers.
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If payment for order flow were banned,
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market makers would still
be able to make money.
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After all, they're still
doing the same thing,
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collecting the bid-ask spread.
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However, the thing that
would likely change
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is that zero commission
trading would be endangered.
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- [Reporter] As the GameStop
saga continues to unfold,
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the future of payment for order flow
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and zero commission
trading remains uncertain.
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(soft tense music)
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