How Order-Flow Payments Work

Why the securities industry embraced the practice and then backed away from it.
Author:
Publish date:

Securities and Exchange Commission

Chairman Arthur Levitt pushed order-flow payments back into the spotlight two weeks ago at a conference in Boca Raton, Fla., when he questioned the practice's effect on execution quality and on price improvement for customer trades.

Let's say Suzy asks her broker to buy 100 shares of XYZ at 55. The broker sees that three market makers would meet that bid at that price, and then sends the order to market-maker ABC, with which the brokerage firm has an order-flow agreement. The market maker then buys XYZ at 54 7/8 and sells it to Suzy's broker at 55. The market maker has thus made a profit of 1/8, or 12.5 cents, per share, and pays the brokerage back a few cents for having sent it the order.

Because the broker is getting paid for sending an order to a certain firm, Levitt questions whether the customer is getting the best deal. "When a broker-dealer sells customer order flow to a designated market maker or exchange, the question of whose interest is being served -- the broker's or the customer's -- is squarely raised," he said during the speech.

Criticism aside, payment for order flow is legal. The SEC more or less condoned it in 1995 when it began requiring firms to include a disclosure statement on the back of order confirmations saying that they may or may not accept payment for order flow.

Until then, explains John Coffee, a law professor at

Columbia University

, it was unclear where regulators stood on the practice, which took off in the 1980s as some off-floor trading houses tried to pull order flow away from the

NYSE

. Rebates grew in

Nasdaq

stocks as market makers profited from wide spreads between the bid and ask prices.

"When you have an artificially wide noncompetitive spread, it makes sense to pay a bribe to your broker," Coffee says. But reforms, namely new order-handling rules set in 1997, cut into those profits, he explains, and the practice started to become less prevalent.

Now Coffee and other observers say that switching stock quotes from fractions to decimals in mid-2000 should deal the final blow to payment for order flow. They say "decimalization" will make it harder for market makers to profit on spreads, reducing market makers' incentive to share the wealth with brokers.