SYLVIE DOUGLIS, BYLINE: NPR.
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DARIAN WOODS, HOST:
Not too long ago, it was kind of difficult to trade stocks. If you wanted to buy or sell, you'd have to call up a broker and pay them a pretty sizable commission.
ADRIAN MA, HOST:
Yeah. And by contrast, today, pretty much anyone with a smartphone and an account at a company like Robinhood or E-Trade or Charles Schwab - they can trade stocks for free. And who doesn't like to get something for free?
WOODS: But that raises a big question - how are these companies making money then? They do it through a controversial practice known as payment for order flow.
This is THE INDICATOR FROM PLANET MONEY. I'm Darian Woods.
MA: And I'm Adrian Ma. Those four words, payment for order flow, have transformed stock trading in the past few years. So today on the show, we explain how it works, where it came from. Hint - it involves a man whose name rhymes with Ernie trade-off.
WOODS: I think I know who you're talking about. And we look at why the SEC, the securities and exchange commission, wants to crack down on the practice.
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WOODS: Payment for order flow - what the heck does this mean? So we'll break it down with the players in a stock trade. You got a customer, a broker and somebody you might not have heard of before - a market maker.
MA: So the customer - that's you - you know, you place that order with a stockbroker, like Robinhood, on an app to buy, I don't know, 10 shares of Indicator Incorporated. And I'm not exactly sure what Indicator Inc. sells.
WOODS: We sell indicators - all the finest indicators.
MA: Get them while they're hot - yes. And so then what Robinhood does is automatically send that order through the tubes of the internet to another company called a market maker. And one of the biggest market makers there is is a company called Citadel Securities. And what Citadel does is try to match up the buyers and the sellers and actually execute the trade.
WOODS: And when it does - the buyer and the seller aren't actually trading with each other at the exact same price. There's this tiny difference. It's called a spread. And the stock is given to the buyer at a very slightly higher price than what the stock originally sold for - just, like, a penny or less. But those pennies add up, and that's where Citadel makes its money.
MA: And this might sound like easy money - right? - like operating a tollbooth on a busy highway. But market making is not without risk. And that is because prices for stocks are always moving around. And if a market maker commits to making a trade and the price moves a lot in a direction they didn't expect, then the market maker can actually be left holding the bag - you know, that fraction of a penny that they were depending on can be wiped out.
WOODS: And this is a particular problem when dealing with smart money, like hedge funds and banks - big professional traders whose massive orders can move prices. In economics, they call this a problem of adverse selection.
MA: Pankaj Jain is a finance professor at the University of Memphis, and he studies financial market design.
PANKAJ JAIN: So if there is a person who knows what the future earnings are going to look like - maybe an insider or some connection with the firm - and if that person is buying from you, you don't want to sell to them.
MA: So that is why market makers don't love doing business with the smart money. By contrast, market makers love taking orders from relatively uninformed traders.
JAIN: People are buying a stock not because they know that the earnings of that stock is going to come out very high during the earnings announcement, but I'm just buying the stock because I got a paycheck for my salary, and I want to invest.
WOODS: So these so-called retail traders - i.e., people like you and me, Adrian - we're not moving markets by buying or selling two shares of Indicator Inc. once a year.
MA: No. As much as I would like to pump up the price of Indicator Inc., I alone cannot do it.
WOODS: And in the early '90s, the head of a market making company had an idea. What if you could just get orders from the uninformed traders? And that company has a name you might have heard of.
JAIN: The oldest memory I have of this issue is a very successful firm, which later on turned out to be a little bit scandalous, was Madoff Investment.
MA: Madoff Investments - and yes, that Madoff - Bernie Madoff. Before he became infamous for stealing billions of dollars in an elaborate Ponzi scheme, Bernie Madoff had a legit business as a market maker. And so when he hatched this plan, we imagine the conversation that followed went something like this.
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WOODS: Hello. Stockbroker here.
MA: Hey, it's Madoff Investments. Look - we appreciate all the orders you've been sending us - right? - the big ones and the little ones. But we were actually wondering, can you send us more of those little retail trades?
WOODS: You mean those piddly little trades from grandparents sending certificates of stocks to their grandchildren for Christmas?
MA: Yeah. That sort of thing is exactly what we want. It is a lot easier and less risky for us to make money on those orders.
WOODS: It sounds like a lot of work.
MA: We can make it worth your while. We make so much money processing those kind of trades where we can actually kick some of it back to you.
WOODS: You will pay us to send this flow of orders from retail traders your way.
MA: That's right. We'll pay you for order flow.
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WOODS: And scene.
MA: And that, in a nutshell, is when payment for order flow took off. But it wasn't that widespread until the mid-2010s. That is when Robinhood came along. They combined Madoff's idea with something even more disruptive - zero-commission trades. Robinhood realized if they can get market makers like Citadel to pay them for orders, they could offer customers their service for free. And so pretty soon, Charles Schwab, E-Trade, Ameritrade - they all followed suit.
JAIN: And that's where we are. Now most of the big brokers - they charge zero commissions. So that was a big source of revenues. If you think about it, brokers' main business - charge brokerage, provide the trading service. Now we charge zero commissions for the brokerage. And so the dependence on payment for order flow all of a sudden has become first order.
WOODS: According to daytradings.com (ph), stockbrokers collected about $3.6 billion in payments for order flow last year. And while the system profiting off order flow payments is currently legal, some financial regulators are saying that maybe it shouldn't be, especially after all the attention that Robinhood and meme stocks got last year.
MA: The big criticism is that payment for order flow creates conflicts of interest. For example, some worry that it could create a situation where a stockbroker like Robinhood might care more about sending its orders to whatever market makers are going to pay them the most, rather than one that's going to give their customers the very best prices for their trade.
WOODS: Thomas Ernst doesn't buy that particular argument. He's been researching payment for order flow at the University of Maryland, and he says that there are rules that say that customers have to be given the best price on their trades. And plus, there's always an electronic paper trail.
THOMAS ERNST: 'Cause it's easy to say, did you give the customer the best price? We can look at the exchange price, look at the price your customer got, compare. That's pretty straightforward.
MA: That said, Thomas is worried about something. The more customers trade, the more fees that brokers get from market makers. And so brokers like Robinhood have a huge motive to get users to trade as much as possible, even when it might not be in the customer's own interest.
WOODS: Research has shown time and time again that people who are very active in trading tend to underperform against the market as a whole. And the other thing that Thomas is worried about is the type of securities that make up most of these order flow payments.
ERNST: If you look at payment for order flow, around two-thirds of all payment for order flow comes from options trades.
MA: Options are a type of security where you're betting on the price change of some stock or asset in the future. And as you can probably guess, it is pretty risky. Compared to stocks, you have a bigger chance of losing your entire investment. And here's the thing - with options, the spread is generally wider. So market makers pay brokers more money for those trades - sometimes twice as much.
ERNST: I think it's actually quite problematic that options trades tend to pay a lot more per order, and that gives brokers kind of perverse incentives.
MA: So payment for order flow - is it good, or is it bad? Well, it gave the world commission-free stock trading. But, you know, sometimes, free also comes with a price.
WOODS: This show was produced by Jess Kung with engineering from Gilly Moon. It was fact-checked by Catherine Yang (ph). Our senior producer is Viet Le. Kate Concannon edits the show. And THE INDICATOR is a production of NPR.
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