On October 3, the Wharton Initiative on Financial Policy and Regulation (WIFPR) will host a webinar on payment for order flow. WIFPR Director Itay Goldstein will moderate a virtual discussion with Tom Ernst (University of Maryland) and Chester Spatt (Carnegie Mellon University) on their new WIFPR white paper, “Payment for Order Flow and the Retail Trading Experience."
You can view the white paper here.
Please register for the webinar here.
Abstract: U.S. retail brokers have shifted to a business model with zero-commission trades, earning much of their revenue through payment for order flow (PFOF), under which wholesalers pay brokers to route the orders of their retail clients. The presence of PFOF has led to potential concerns about whether it leads to distortions in routing decisions by brokers, a reduction in market quality due to its effect in segmenting retail orders, or changes in the brokers’ incentives to encourage excess trading. While the recent SEC regulatory focus has been on equity markets, two-thirds of all PFOF comes from option markets. PFOF rates in option markets are much larger, creating a system where broker revenue is much higher when retail clients trade options compared to equities, leading to potential incentives to encourage option trading. We consider the current SEC proposal for order-by-order auctions in retail equity trading and its implications for retail investor welfare. We address three alternatives. First, we propose an expansion of equity Retail Liquidity Programs rather than mandated retail auctions. Second, we consider changes to option markets to reduce frictions, which could include fee caps, competitive designated-market-maker assignments, and a more competitive auction process. Finally, we suggest a PFOF-fee cap, which would preserve PFOF, while addressing the large cross-asset PFOF fee differences.