There has been a lot of discussion about the question, in particular about where and how brokers route their customers’ orders. As someone who spent his professional life trying to empower people to make informed investment decisions, I understand the concern. But it’s misplaced.
Consider the vast improvements in stock markets. Individual, or retail, orders get filled 10 times faster than a decade ago. Commission rates have fallen by nearly 70% since 1997. The prices at which orders are filled beat quoted prices 91% of the time, versus 14% a decade ago. And 99% of all market orders are filled in their entirety.
The supposed problem is what happens after an individual investor enters an order to buy or sell a stock. At this point the broker is legally obligated to try to make the trade at the most favorable terms reasonably available—including such factors as price, speed, the likelihood of partial or full execution, transaction costs, and customer needs and expectations. This obligation, called “best execution,” is a big deal; it is why regulators like the Securities and Exchange Commission and the Financial Industry Regulatory Authority require brokers to conduct regular, rigorous reviews of their execution quality.
A significant factor in determining the best execution involves where orders get routed. The broker who took the order may try to match buyers and sellers among his business’s clients in-house—called internalization—or he may send the order out to a third-party market center. Market centers include electronic exchanges like NYSE and Nasdaq, as well as market makers, which are firms that trade for their own accounts to make markets in particular securities.
Market centers compete fiercely for order flow. In part, that’s because they need strong order volume to produce robust trading and liquidity. When the market for a stock is liquid, it means investors are actively buying and selling it, and that means trades can be executed quickly and at good prices. The fact that the current equity-market structure has generally produced robust liquidity is one of the main reasons orders are getting filled faster, cheaper and at better prices.
Some market centers compete for order flow by paying brokers to get their orders, usually small fractions of a cent per share. And this is what all the recent brouhaha is about—irresponsible assertions that competition among market centers for order flow has led brokerages to ignore their best execution obligation and simply channel orders to the market center that paid them the most.
Yet there is nothing shadowy about market centers competing for order flow. Paying for order flow began in the late 1990s and has been well-established in the U.S. since the mid-2000s. Since 1994 the SEC has required broker-dealers to disclose publicly to new customers, on trade confirmations and in public quarterly reports that they are receiving order-flow payments.
The effect of this transparent competition has been extremely positive for retail brokerage clients. According to data analysis firm RegOne Solutions, competition among market centers for order flow has resulted in retail investors receiving more than $600 million in direct price improvement to buyers and sellers from market centers in 2014 alone, up from roughly $100 million in 2004. And that doesn’t take into account the extent to which revenue from payments for order flow permit brokerages to offer lower commissions and, in many cases, free extra services such as powerful technology platforms, access to third-party research reports and online education.
There is no doubt the industry can do even better. Providing investors with more and easier access to information about payments for orders will permit them to decide if they are comfortable with their broker’s routing practices. If not, they can take their business elsewhere.
But improvements need to be thoughtful, measured and informed by the fact that the current market structure has produced incredibly favorable conditions for individual investors. It is a mistake to obsess over one practice without considering how it, and all the other pieces, work together to produce the current, favorable environment for retail traders. As with doctors, the first rule should be: Do no harm.
Mr. Ricketts, the founder of TD Ameritrade, now pursues entrepreneurial and philanthropic projects. Alfred Levitt, president and general counsel of Hugo Enterprises LLC, helped with research for this op-ed.