With less than six months on the job as the chairman of SEC, Mr. Gary Gensler has introduced a sweeping agenda that aims to squeeze Wall Street’s profit margins, crack down on crypto, and address new issues in retail investment. While some doubt how effective the SEC will be at enforcing Gensler’s agenda of roughly fifty new rule-making items at once, the opposition hasn’t stopped Gensler’s campaign of reform.
Many of Gensler’s policies aim to protect investors from big finance, and Gensler’s resume demonstrates he has a history of advocating for ordinary investors and their rights, despite ties to the financial industry. Before going into public service, Gensler was a partner in Goldman Sachs’ Mergers & Acquisitions group. However, he left in 1997 to join President Clinton’s Treasury Department and, after leaving Treasury, he co-wrote a book that stringently criticized the mutual fund industry. More recently, he led the Commodity Futures Trading Commission under President Obama and developed a reputation as a “hard-charging” regulator. During his tenure, he wrote dozens of rules to govern the vast swaps market which had previously been mostly unregulated and contributed to the 2008 financial crisis.
However, this much isn’t new for the SEC — protecting Main Street from the rampages of Wall Street is part of the agency’s mission. What distinguishes Gensler and his regulatory changes from the past chairs is his goal of protecting investors through new policies addressing concerns about high-speed trading and online brokerages.
Gensler’s primary target to address these concerns is “payment for order flow.” Payment for order flow, the practice of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution, allows Robinhood Markets Inc. and other online brokerages to make commission-free trading available to retail investors. To do this, Robinhood sends its clients’ orders to high-speed trading firms such as Citadel Securities instead of a stock exchange. (High speed trading is a trading strategy that involves buying and selling financial securities at a very high-speed using algorithms.) The trading firms pay Robinhood for sending them the orders, and then profit from the difference between the buying and selling price of the shares being transacted.
The critics of payment for order flow, including Gensler, argue that this process poses a conflict of interest for brokers and reduces transparency in the market by channeling data away from exchanges. SEC has also expressed its concern that payment for order flow and internalization contribute to an environment in which quote competition, instances of specialists trading through a better quote on another exchange, is not always rewarded.
However, Citadel Securities and Virtu, two of the market makers that dominate this business, say they often execute trades at a slightly better price than exchanges and save money for investors. “Concerns about concentration and conflicts are theoretical,” said Douglas Cifu, the chief executive of Virtu. “The actual results are overwhelmingly beneficial to individual investors.”
In August 2021, Gensler stated that he was open to banning payment for order flow altogether, which is a practice that accounts for the majority of online brokerages’ revenue.
Gensler has also criticized the new generation of brokerages for using data analytics to study how clients behave instead of appointing human brokers to take orders from clients and recommend investments directly. “While these developments…can increase access, increase choice, and lower costs, they also raise new questions about potential conflicts, biases in the data, and yes, even systemic risk,” Gensler told the Senate Banking Committee in September.
While many brokerage companies argue that heightened regulations of payment for order flow would result in increased compliance costs and materially decrease their transaction-based revenue, some, including their clients, believe otherwise. For instance, Kenneth Griffin, the founder of Citadel Securities, said that he would be “quite fine” if payment for order flow was banned.
Ultimately, while it may be lucrative for retail brokers to use this practice of providing zero commission stock and options trading to their clients, this process is now heavily scrutinized by regulators and some changes are inevitable. Opponents of this practice argue that it passes hidden costs to investors and generates volumes of data that firms can use to track the market. Rather than banning payment for order flow outright, Gensler’s regulatory agenda could be achieved by implementing disclosure requirements which require brokers to be more transparent and publicly disclose to retail investors how they profit from the arrangement. Though a disclosure-based approach may take longer to achieve Gensler’s agenda than some investor advocates had hoped, it would allow for more fine-tuning than a complete ban.
Additional disclosure requirements would require brokers to adjust their practices and business models. In the long run, this approach would cut costs for the market, help ordinary investors save money by making them more conscious in their choices, and could also benefit financial institutions as additional disclosures and transparency would lead to reduced scrutiny by the regulators moving forward. Furthermore, a changeable disclosure regime to address payment for order flow would free up Gensler and the SEC to focus on bigger and more important issues including climate change and promoting social benefits through securities regulation.