Payment for order flow on Nasdaq business could soon be facing extinction. The profit on each Nasdaq trade, which once enabled a market maker to pay an order-entry firm around two cents a share for order flow, has shrunk threatening the rebates vital to some discount brokers.
"Payments have been cut about 50 percent across the full range of orders," said Leonard Mayer, president of New York-based Mayer & Schweitzer, a Charles Schwab Corporation affiliate and leading Nasdaq market maker.
"Quite honestly, I think payment for order flow on Nasdaq business will soon be a thing of the past," said Tom Dudenhoefer, head of Nasdaq trading at St. Petersburg-based Raymond James & Associates.
But while a cut in half may seem significant, Mayer contends that payment on marketable orders orders that enable the dealer to profit on the spread is not down as significantly.
One industry expert said that while payments on limit orders are down dramatically, payments for marketable orders are still close to historical levels. In fact, the 50 percent reduction does not reflect a cut in all payments, but mostly the dramatic drop in limit-order payment, the expert added.
Mayer said his firm no longer pays for limit orders, because the vast majority do not offer the opportunity to make a profit. The firm will continue to pay for marketable orders.
"Mayer & Schweitzer does not pay for limit orders anymore," Mayer added. "And I would say that generally, market makers have ended the practice of paying for limit-order flow."
Jerry Kasten, a specialist on the Boston Stock Exchange for Garden State Securities,
agrees. "Nobody pays for limit orders because no money can be made," he said.
Kasten added that payment for pure market orders on strong stocks remains close to normal levels, with rebates around two cents a share. But payments for less stable stocks has dropped to below a penny, he said.
The Practice
A payment-for-order-flow arrangement is typically forged between a discount order-entry firm and a broker dealer. Generally, it refers to the payment of cash by dealer firms to brokerages to induce them to send aggregated small orders to purchase or sell securities to the dealers for execution.
Often, it is discount firms that enter into the order arrangements to subsidize their low commissions with the fees from broker dealers typically a penny or two a share.
Payment for order flow has long been a controversial part of Wall Street trading. A broker's fiduciary duty is to obtain the best possible execution for a customer's order. But the obvious temptation is to send orders to the market maker offering the highest rebate, regardless of best execution.
But last year, the practice survived a Supreme Court challenge, and the Securities and Exchange Commission has ignored frequent requests to ban the arrangements.
"There is very little in the securities industry that does not involve some sort of back scratching," said Andrew Davis, a Chicago Stock Exchange (CSE) specialist for Rock Island Securities. "Payment for order flow is a valid and well-regulated part of the business. With a lot of other types of deals, the customer never really finds out what is going on."
On listed business, payment for order flow is an important element of trading on the regional exchanges. Davis estimates that half of the CSE's total volume is paid order flow. "Among third-market firms and other regional exchanges, I would guess close to 80 percent of order flow is paid for," Davis added.
Davis explained that the rebate structure for order flow is quite complex, involving a ranking of tiers of stock. Firms distinguish which stocks offer the best chance of profit weighing spreads, liquidity, activity and history and set their payments accordingly. Davis said payments for the top tier, perhaps strong performing blue-chip stocks, could run two cents a share. A Standard & Poor 500 stock, on the other hand, could rebate between a penny and two cents a share.
"Payments have gotten more complex over time," Davis said. "These payments are essential for discount brokers and order-entry firms. Retail customers are choosing this equation, because it works for them."
The Threats
But it is the economics of declining profitability, not regulatory or customer objections, that threatens the practice on Wall Street.
"Spreads have narrowed a full third and profitability is down, so dealers are more sensitive to paying," said Jack White, founder of La Jolla, Calif.-based discounter Jack White & Co.
As a result, White's firm has shifted the focus from sending orders to dealers for payment. "We are continuing to develop a vital electronic crossing network for our retail orders," White added. That system, first activated on the Internet in September 1996, had early operational problems.
"The future of the equity markets is customers crossing shares rather than going to the dealers," White said. "The dealer market is dying."
White believes that customers want developed electronic systems to bring together the two sides of a trade. "Dealers are not providing as much liquidity," he added. "The liquidity is coming from the public."
With the order handling rules requiring market makers to display customer orders to the entire market, many of the limit orders brokers receive are priced better than the current quotes. These limit orders an order to buy or sell a stock at a prespecified price do not enable a dealer to profit from the execution.
Nasdaq spreads narrowed more than 30 percent after the order handling rules took effect, and still further with the widespread trading of stocks in sixteenths.
"I would say the reduction in payment for order flow has occurred because of the economics of narrower spreads and the execution of many more flat trades," Mayer said. "The profit margins of market makers have been reduced, which brings about a reduction in payment."
The Future
Daniel Weaver, an associate professor of finance at New York's Baruch College, suggests that while widespread order-flow payment may decrease, it will not disappear. "It allows firms to design and control their order flow," Weaver said. "If you can control who you get orders from, you can make more money than by just taking orders as they come."
Mayer agrees. "I am always cognizant of marketing to firms with a more desirable order flow," he said. "I have more interest in a natural selection of orders from customers making investment decisions. I have less interest in order flow emanating from day traders and momentum players."
On the CSE, Davis said most specialists have not cut order-flow rebates. At the moment, they are examining the changing economic structure of the industry. Davis believes minor adjustments in CSE rebates may be made this year.
Davis is president of The Association of CSE Specialists (ACSES), a four-year-old cooperative that oversees operational matters for roughly two-thirds of the CSE's specialists.
"It is naive not to recognize the value in the flow of orders," Davis said. "No one gives away business. But the way we do it [at ACSES], we take the high road and let everyone know what is going on." ACSES files payment reports with the CSE, the New York Stock Exchange, Nasdaq and the Internal Revenue Service.
Mayer contends that order-entry firms should focus on best execution of their customer orders, and route orders to a market maker providing consistent, quality executions and exceptional service. In selecting a market maker, he suggests, an order-entry firm should consider those that have advanced features and provide a positive impact on their customer's executions.
"Regardless of payments, customers should come to a market maker for its service," Mayer added. "Systems and service should distinguish market makers from one another, with those at the top providing superior execution."
