Photo by Mike Lawrence

Electronic Trading Firms and Payment for Order Flows

Electronic trading firms have become a rising force in financial markets. These firms engage in high-frequency trading using advanced computer algorithms. They also serve as market makers, providing trading services for investors that helps promote market liquidity. Some of the biggest industry players include Citadel Securities, Virtu Financial, Susquehanna International Group, Wolverine Trading Company, Jane Street, and Two Sigma Investments.

Observers estimate that electronic trading firms account for around half of the equities trading volume in the United States. The ultra-fast speed with which computer algorithms can sort data enables them to take advantage of unique arbitrage opportunities. These programs can spot price discrepancies between securities and capitalize on price fluctuations. Arbitrage strategies can take a variety of forms. Examples include volatility arbitrage, index arbitrage, merger arbitrage, events arbitrage, and global macro arbitrage.

Electronic Trading Firms Arbitrage
Electronic Trading Firms Arbitrage
Photo by Mike Lawrence

The use of arbitrage strategies has attracted regulatory scrutiny. There are also risks from software malfunctions. In 2012, Knight Capital Group veered close to bankruptcy after it lost $400 million in a single hour due to a trading glitch caused by apparent software malfunctions. After the incident, authorities imposed increased risk management obligations on algorithmic electronic trading firms.

Payment for order flows has gained increased attention in 2021. This has occurred in the wake of the GameStop trading saga and the Congressional testimony that followed. Payment for order flows refers to the practice whereby market makers pay brokerage firms to execute customer orders. Market makers are electronic trading firms that execute the orders received from online brokerages such as Robinhood and TD Ameritrade.

Market makers provide liquidity to the market by buying and selling orders immediately. In bridging this time gap, they take on additional risk. For example, it is unlikely that at any given second there will be buyer that placed an order to buy 543 shares of a particular stock and a seller that placed an order to sell exactly 543 shares of that same company’s stock. Without market makers, it would be much harder to unwind your shares or buy new shares quickly. The cause would be a lack of market liquidity.

Brokerage firms typically have prearranged agreements with market maker firms, such as Citadel Securities, Virtu Financial and Susquehanna. These electronic trading firms will then compete for the order flow.

The market makers generate profits through the difference in the bid-ask spread. In other words, these firms place orders to buy securities slightly above the market price and place orders to sells securities slightly below the market price. These firms get to keep the difference. Although these price differences are quite small, with large order volumes they add up to significant profits for these electronic trading firms.

The payment for order flows industry saw its profits soar in 2020. This was partly attributable to a rise in the number of retail investors participating in the markets. The accessibility of trading apps such as Robinhood Financial and collective discussions on social media platforms such as Reddit has fueled retail investor participation.

Options accounted for approximately 60.9% of the payments order flow in 2020. Notably, Citadel Securities, considered the leading global market maker, made 41.7% of payments for order flow in 2020.

Payment for order flows has attracted increased public scrutiny in the wake of the GameStop trading saga. Robinhood CEO Vlad Tenev stated that “payment for order flow helps cover the costs of running our business and offering commission-free trading to customers.”

Better Markets has argued that payment for order flow “is widespread and causes an inevitable conflict-of-interest between the retail broker-dealer’s duties to seek best execution for its customers and its duties to shareholders and others to maximize revenues. These execution costs can outweigh the benefits to retail investors associated with so-called “commission-free trading.”

Virtu Financial, a top three global marker maker, has rebutted these assertions. Virtu CEO Doug Cifu notes that competition between electronic trading firms for payment for order flow volume is high, mitigating the risk of price manipulation. Cifu explains: “most of the brokers have a ‘routing wheel,’ and within that wheel, they will send client orders to the market makers based on the amount of price improvement they have provided.”

Payment for order flow activity is regulated by SEC Rule 606. This rule requires brokers that route orders in equities and options securities for customers to comply with certain disclosure guidelines. Rule 606 mandates that information be disclosed about how client orders are handled and to publish quarterly reports outlining their methods.

Rule 606 is designed to promote competition in order execution price and quality as well as overall transparency. Some lawmakers have suggested that they would like to see amendments or further regulations imposed upon electronic trading firms.

Ken Griffin, the CEO of Citadel, stated that his firm would be ready to adapt to such regulatory changes. Griffin commented: “We simply play by the rules of the road. Payment for order flow had been expressly approved by the SEC, it is a customary practice within the industry. If they choose to change the rules of the road, we need to drive on the left side versus the right side, that’s fine with us.”

Ryan Carpenter serves as Attorney and Managing Director of Carpenter Wellington. Ryan advises clients across a broad set of corporate and commercial matters.

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