In an op-ed published in The Washington Times this week, ATR Federal Affairs Manager Bryan Bashur emphasizes the importance of payment for order flow (PFOF) as an innovative component of stock trading that has allowed brokers to eliminate commissions for individual investors.
The deregulation of stock trading commissions in the 1970s launched a surge of new investments and cut costs for individuals to participate in the stock market. As Bashur points out:
The transition from fixed-rate commissions to zero commission trading began during the Nixon administration. In September 1973, the Securities and Exchange Commission announced that starting in 1975, fixed-rate commissions on stock trading would be eliminated. This allowed brokers to charge different rates for each trade. Instead of a flat fee for buying 10 or 10,000 shares, market competition would set commission rates.
The SEC’s action significantly lowered the cost of trading for individual investors. According to The Wall Street Journal, brokers immediately cut commissions by at least 50%. This was a watershed moment for individual investors. In 1975, Charles Schwab admitted as much by saying that “deregulation provided the window for people to being to innovate” and that it “turned the whole industry upside down and led to this great mass flourishing of services and pricing and technology.”
When commissions were reduced, the volume of trading increased. In July 1985, The Washington Post reported that trading volume “soared five-fold.”
Eventually, brokers found ways to make trading stocks more affordable for everyone by cutting commissions to zero. By earning revenue through a process called payment for order flow (PFOF), brokers were able to maintain zero commission regimes. As Bashur explains:
Another watershed moment occurred when brokers decided to eliminate commissions. In 2013, Robinhood launched and offered zero commission trading. In 2019, Interactive Brokers offered its first zero commission product, IBKR Lite. Soon after, a wave of major retail brokers such as Charles Schwab, Fidelity, TD Ameritrade and E-Trade cut commissions to zero.
Many brokerages have earned revenue by accepting payment for order flow (PFOF), which has allowed them to maintain zero commission regimes. Brokers send trade orders to firms that connect buyers with sellers (e.g., wholesale market makers) such as Virtu, Citadel Securities, Two Sigma and Susquehanna. These firms earn revenue from the difference between the bid and offer price on a trade and pay brokerages a fee for routing the orders for execution.
Zero commission trading, which is made possible by PFOF, cuts costs and improves order execution for individual investors. Bashur highlights that:
The market makers compete to provide the best possible execution of each trade. This private competition is lowering costs for individual investors. According to Coalition Greenwich, in 2018, “market makers provided an average of $6.18 in savings per order.” These individual savings amounted to aggregate savings of more than $1.3 billion for individual investors. Additionally, from July 2018 to June 2019, 87% of retail market order shares showed price improvement, and almost 95% of retail market order shares experienced best execution.
Unfortunately, SEC Chairman Gary Gensler has threatened to ban PFOF and terminate all the benefits for individual investors that come with it. Bashur states that:
Earlier this year, Mr. Gensler took a sledgehammer to the discount brokerage industry when he told Barron’s that he was amenable to banning PFOF. It seems that every chance Mr. Gensler gets, he is willing to have his agency wedge its way into free-market competition. First, Mr. Gensler claims private cryptocurrencies are too unwieldy and need more regulation. Now the entirety of the zero-commission revolution is at risk of collapsing if he follows through with his assault on PFOF.
Bashur concludes by saying that lawmakers should protect PFOF. Senator Pat Toomey’s (R-Pa.) bill, the Investor Freedom Act of 2021 (S. 3102) would do just that.
Less government interference and more deregulatory actions within the equity trading ecosystem will accelerate the innovation needed to enable more individual investors to be active participants in the United States’ capital markets.
Click here to read the full op-ed.
Photo Credit: “CMI 101: Demystifying Derivatives with CFTC Chairman Gary Gensler” by Third Way Think Tank is licensed under CC BY-NC-ND 2.0