Payment for Order Flow

A U.S. retail investor sends out an order to buy or sell a stock through a brokerage account. She may think her trade heads directly to the New York Stock Exchange, but that’s rarely true. Instead, electronic wholesale firms often end up carrying out those requests. In most cases, the firms pay retail brokers for the right to execute these customer trades in a widespread practice known as “payment for order flow.” It’s a system credited with lowering trading costs for mom-and-pop investors — but regulators wonder whether it’s ultimately in their best interest.

Two firms dominate the arena of carrying out retail trades: Citadel Securities and KCG Holdings. About one in five trades in the U.S. stock market are handled by wholesalers, according to research firm Tabb Group. But regulators have expressed some trepidation about broker payment systems. While they have not banned payment for order flow, regulators have called into question whether it presents conflicts of interest in how retail brokers route their customers’ trades. They’ve also warned about how brokers price customer orders, and differences between the fastest, priciest data feeds and their slower-moving counterparts. The U.S. Securities and Exchange Commission asked a committee of advisers whether the systems should be banned or altered — but hasn’t taken any steps yet to change the practice. Regulators are also taking a broader look at how individual investors’ trades get carried out. The SEC fined Citadel Securities $22.6 million in January, saying the firm inaccurately described how it handled trades placed by small investors.