Mar. 16, 2023
Dear Ms. Countryman, I am an individual investor and would like to express my gratitude for the chance to share my thoughts on the SEC’s Best Execution Proposal and NMS Proposal, collectively known as “The Proposals.” My comment covers Payment for Order Flow (Wholesaler PFOF) and exchange rebates (Exchange PFOF), collectively referred to as PFOF. While PFOF is primarily viewed as an off-exchange incentive to route orders to wholesalers, exchange fee structures also play a role. Rebates also influence order routing decisions. I believe that these issues should be examined together. In short, these incentives should not exist and should be prohibited. The Commission and FINRA have long acknowledged the problems caused by these incentives, but despite regulators’ best efforts, these problems have not been resolved. Simply put, The duty of Best Execution is not compatible with PFOF. Research from both independent academics and the Commission, as outlined in The Proposals and the OCR Proposal, shows that brokers who accept Wholesaler PFOF receive less price improvement and that this practice is incompatible with the duty of best execution. Brokers who do not accept any PFOF route orders differently and achieve better execution quality. This is not just a theoretical debate; it has real negative consequences for individual investors. Doug Cifu, CEO of wholesaler Virtu Financial, confirmed this during a CNBC interview in March 2021 when asked if a retail investor at Fidelity (which does not use PFOF) gets a better price than one at Robinhood. Cifu replied that Fidelity receives more price improvement than Robinhood over the course of a month. This goes against FINRA’s best execution guidance which states that firms may not negotiate order routing arrangements in a way that reduces price improvement opportunities for customer orders. A recent study found that Robinhood does not provide statistically significant price improvement compared to exchanges when controlling for market conditions. This is significant since PFOF accounts for about 70% of Robinhood’s revenue - money that goes to Robinhood instead of its customers. Robinhood does not provide statistically significant price improvement and has a history of misleading its customers and failing to fulfill its duty of best execution. The NMS Proposal presents a strong argument for banning rebates. The only disadvantage mentioned is that it limits exchanges’ ability to innovate with rebates. However, the NMS Proposal acknowledges that access fees and rebates tend to increase transaction costs for liquidity demanders and exacerbate liquidity oversupply for stocks with narrow spreads while doing little to improve liquidity in stocks with wide spreads. The Commission recognizes that rebates do not improve liquidity in stocks with wide spreads while increasing liquidity oversupply in stocks with narrow spreads. Like Wholesaler PFOF, Exchange PFOF harms market quality by providing unnatural subsidies to a few firms and increasing market power concentration. In 2017, the SEC’s Equity Market Structure Advisory Committee was informed by its Customer Issues Subcommittee that addressing exchange rebates was the most important equity market structure issue due to conflicts of interest associated with exchange rebates. Current solutions are inadequate in addressing this systemic problem. The Commission has taken a piecemeal approach by setting an artificial price control for access fees in the NMS. The Best Execution Proposal offers check-the-box solutions for “conflicted transactions” while the NMS Proposal sets an artificial price control for access fees. It is unclear why institutional investors are excluded from these exceptions. The solution is straightforward - the Commission must ban order routing incentives such as PFOF that are unrelated to execution quality. Numerous studies have examined the effects of PFOF over the past decade. The Commission’s CAT analysis provides a good overview of the problem with Wholesaler PFOF, but Exchange PFOF receives little attention. Exchange PFOF harms investors in much the same way as Wholesaler PFOF does. Competition for high rebates drives take fees to the maximum allowed by the access fee cap, resulting in higher costs for both institutional and individual investors who place marketable orders. This is why the access fee cap is similar to a government-imposed price control. The conflict of interest between brokers and their clients leads brokers to place non-marketable orders at exchanges that offer the highest rebates instead of those with the best execution quality. This results in long queues, decreasing the chance of execution and increasing the risk of adverse selection. The Commission recognizes this issue and cites academic research showing that high liquidity fees and rebates on some market centers can influence broker-dealer routing decisions based on where they can get the highest rebate or pay the lowest fee rather than where they can achieve better execution quality for their customers. According to IEX, in some cases brokers who try to maximize their rebate payments from exchanges can earn more in rebates per share than what their clients pay them in commissions per share. This results in a significant decrease in the client’s execution quality. Exchange PFOF increases the number of exchanges because rebates and the Order Protection Rule ensure that any price queue will be filled. However, it reduces the number and diversity of trading participants in the same way as Wholesaler PFOF. Almost all net rebates are paid to a few trading firms, increasing concentration by providing subsidies to the largest high-speed trading firms at the expense of other firms. The issues with Exchange PFOF and Wholesaler PFOF have many similarities. The Commission’s economic analysis of the costs of Wholesaler PFOF provides the most detailed and data-driven picture available. This analysis quantifies many of the criticisms that have been made against this practice over the past 15 years. I commend the SEC for their thorough economic analysis and excellent data included in the Proposals. This analysis should dispel many of the arguments made by supporters of the status quo on cable networks to maintain their exclusive flash order facilities: “[W]holesaler price improvement is not commensurate [sic] their lower costs" “[T]he isolation of individual investor orders due to wholesaler internalizations may result in larger losses in potential price improvement for individual investors on their orders in less liquid stocks. As we know from Doug Cifu’s CNBC quote above, “execution quality varies based on whether the retail broker receives PFOF for NMS stock orders.” Most importantly, thanks to the Commission’s CAT analysis, we also know that “results indicating brokers that receive PFOF receive inferior execution quality are robust to the inclusion of controls for differences in the type of order flow coming from different broker-dealers.” Different levels of adverse selection do not explain variability in price improvement. PFOF does. Public, a retail broker that does not accept Wholesaler PFOF, provided a public analysis of its execution quality compared to its competitors. Public explained how Wholesaler PFOF conflicts with the obligation to provide best execution. Wholesaler discretion results in “good-enough execution,” which falls short of the Best Execution standard. Banning PFOF will not end zero-commission trading for two main reasons: many brokers already offer zero-commission trading without accepting PFOF and it exists in countries where PFOF is banned. The industry often conflates zero-commission trading with zero cost trading, but there are still hidden and implicit costs to trading in a zero commission model. If investors have to bear costs for trading and investing, the Commission should favor explicit costs. As stated by Allison Bishop in a Medium article, trading fees are more transparent to consumers than missed price improvement and are therefore more subject to competition. Other countries have taken measures to reduce or eliminate Payment for Order Flow (PFOF). The UK’s Financial Conduct Authority (FCA) has long held that PFOF is incompatible with their rules on conflicts of interest and inducements and risks compromising firms’ compliance with best execution. They specifically mention the incompatibility of PFOF with the duty of best execution and wider bid-ask spreads from market makers who pay PFOF to attract order flow. Singapore has also banned PFOF due to conflicts of interest and harm to customers. Like the UK, they identified wider bid-ask spreads as a direct result of this practice. The EU is currently in a debate over PFOF with regulatory authorities pushing for a ban while individual countries are being lobbied by PFOF brokers. ESMA’s guidance states that it is unlikely that the receipt of PFOF by firms would be compatible with MiFID II. The US is unique in allowing both types of Payment for Order Flow (PFOF). In most other markets, exchange rebates are not allowed. The US can learn from markets such as Hong Kong, Japan, Australia and Euronext. Publicly traded institutional asset managers have expressed their views on PFOF. T Rowe Price wrote a comment letter supporting the reduction or elimination of rebates and stated that it would not have any significant or harmful effects on the quality of prices. The goal should be to improve the market so that prices can be set by long-term investors without distortion from speculative market participants. Vanguard also states on its website that they do not receive any form of payment for order flow and their approach is rooted in their “client first” philosophy. Vanguard recognizes that being a caretaker of client investments is not compatible with Payment for Order Flow (PFOF). Capital Group has also been a leader on this issue. In 2015, Matt Lyons, SVP and Global Trading Manager at Capital Group testified before the SEC’s Equity Market Structure Advisory Committee and recommended the elimination of rebates. This would alleviate many issues including increased fragmentation, complexity and fragility; fee-sensitive routing; excessive quote-to-trade ratios; and exchange fee structure complexity. There are alternatives to a ban. If the Commission continues to allow Payment for Order Flow (PFOF), which causes harm to individual investors, changes should be made to reduce the conflicted nature of these inducements. The access fee cap acts as a rebate cap and analysis suggests that access fees remain near 30 mils on most exchanges to fund rebates. Harmonizing trading and quoting increments could benefit investors due to potential long-term competitive effects. A rebate cap for Wholesaler PFOF should be implemented in the same way as it constrains Exchange PFOF. A universal fee and rebate cap would be consistent with the overall objectives of The Proposals. If the Commission insists on maintaining an access fee cap, 10 mils seems as good a number as any. Simplicity and transparency are important. Exchange fee and rebate structures are complex. A 2018 report by RBC found that there were 1,023 separate pricing paths across public exchanges, a 22% increase from their initial report in 2016. Of these paths, 37% consisted of rebates. There were at least 3,762 separate pricing variables across the exchanges suggesting that exchange prices are tailored on a bespoke basis. The Commission recognizes the importance of simple fee structures and proposes that all fees and rebates for auctions must be the same rate for segmented orders in all auctions. This uniform rate is designed to promote a level playing field among market participants and prohibit volume discounts that could give larger participants an economic advantage. Why does the Commission acknowledge that tiered fee structures create an unlevel playing field in the OCR Proposal but not extend this principle to the NMS Proposal? I urge the Commission to apply this principle broadly to exchanges to eliminate complex fee structures and fee tiering that create conflicts-of-interest and affect order routing behavior. The biggest critics from The Proposals' endorse it. Several firms are criticizing The Proposals made by The Commission as they pose a threat to their earnings and bonuses. However, it’s important to note that many of these firms have previously endorsed the reforms advocated by me before they profited from these practices. Intercontinental Exchange CEO Jeffrey Sprecher once said that he would like regulators to outlaw maker-taker pricing and that payment for order flow is bad for markets. It creates false liquidity by attracting people who are only interested in making rebates and not trading or holding risk. In 2021, Citadel Securities founder Ken Griffin said he would be fine if payment for order flow was banned as it is a cost to him. In 2004, Citadel asserted that payment for order flow creates conflicts of interest and should be banned. Virtu was a founding member of the Healthy Markets Association in 2015 which aimed to eliminate PFOF and rebates. Current employees of Virtu have expressed concerns about the problems PFOF presents. The Commission will hear many arguments from brokers and exchanges to maintain the current situation. These arguments will include the notion that Payment for Order Flow (PFOF) adds a lot of liquidity to the market and that wholesalers are getting investors the same prices as the best quotes posted on exchanges. These arguments were made by Bernie Madoff. However, some of the strongest arguments in favor of banning PFOF come from brokers and exchanges themselves. It’s time for a change. The incentives and inducements of Payment for Order Flow (PFOF) distort order routing and violate the principles of best execution. This undermines the fairness, simplicity, and transparency of markets and creates a system where investors cannot interact directly and their orders are used for the benefit of high-speed speculators. There are few reasons to keep the current system and many compelling reasons to end this unequal practice. One of the main reasons is that we are legally obligated to do so under the duties outlined by Best Execution. Sincerely, Carl Richard Hoopingarner II CEO at Pathfinders Co-Founder at Level Up Education