By Opposing Small Cap Market Reform, Wall Street’s Largest Retail Brokers are Putting Their Economics Ahead of Customers’ Best Interests

Scott Kupor

Photo: Epicharmus

Photo: Epicharmus

According to SEC Chairwoman Mary Joe White, implementing a pilot program to widen tick sizes for small-cap stocks (sub-$750 million market cap) is a “near-term project” for the SEC. In other words, it might actually happen, and that has some of the biggest players on Wall Street in a panic.

Widening tick sizes and restricting the increments at which small-cap stocks can trade – a change for which I and others have been advocating – would bring more liquidity to the small-cap marketplace.

To retail investors – who comprise about 80 percent of the small stocks – this would bring institutional investors back into small-cap stocks, helping both increase stock prices, reduce volatility and provide much needed expansion capital. To small-cap companies, this would mean access to the capital needed to grow their businesses, invest in innovation and create jobs. And to the broader U.S. economy, this would create more IPOs and thus the attendant job growth. In other words, the rising tide of liquidity would float all boats.

That all sounds great. So, why are the largest retail brokers, Fidelity, TD Ameritrade and others, sounding the alarm bells? If widening tick sizes is good for retail investors, why do they think the opposite – that doing so will in fact hurt the retail investor?

Probe a little deeper and you get to the root of their concerns. They aren’t out to protect the retail investor; rather, they are fighting to protect the economics of their retail investor-driven business models. Business models that drive profits not just in small caps, but through every strata of the market up to the highest volume, large cap stocks.

To understand this, we need to take a detour into the annals of stock market trading – in fact back to a practice started in 1980 – to see what actually happens when you place a retail stock trade order.

It turns out that, in nearly all cases, when you place a retail stock trade order, the retail brokerages don’t actually execute the trade themselves. Rather, they sell those orders to other institutions commonly referred to as “internalizers.”

These internalizers – among them are companies like Citadel, Knight-Getco, Citigroup, UBS, Goldman Sachs, National Financial Services – pay the retail brokers as much as $0.32 per 100 shares traded, according to reports. This is a practice known as “payment for order flow.”

Yes, those are small numbers, but given the large stock trading volumes in the overall stock market, these little payments can add up to real dollars. For example, Reuters estimates that in 2012 TD Ameritrade received $200 million in fees for directing orders to internalizers, representing about 8 percent of total annual revenue and 20 percent of its pre-tax income. Knight-Getco alone paid an estimated $90 million in fees in 2012 to various retail brokers for order flow.

To be clear, this is not an illicit practice in the U.S. In fact, it’s sanctioned by the SEC (and firms report on it via a form known as a Rule 606 Report). Other countries (Canada and Australia) have outlawed the practice and some (the U.K.) have increased their regulatory scrutiny recently, recognizing the inherent conflicts of interest this practice can create.

But, what does any of this have to do with wider tick sizes? Well, under today’s rules, payment for order flow thrives because the internalizers take virtually no trading risk when they accept orders from retail brokerages. To satisfy the SEC’s National Best Bid & Offer rules (NBBO), internalizers need only realize a small bump up in stock price, literally fractions of a penny, to execute the trade. As a result, they will take (almost) whatever they can get, and happily pay for the privilege.

If, however, small-cap tick sizes are widened to $0.05 and trades can occur only at the bid, ask or mid-point, internalizers would need to price improve by at least 2½ cents. In this case, the trade goes from almost a zero-risk proposition to one that requires that they actually take some level of market risk. Instead of stepping ahead of the displayed quote by a fraction of a penny, they would need to do so by at least 2½ cents. This probably means their willingness to pay for order flow goes down, and with it goes the fee income to retail brokerages.

And the financial pain to the brokerages could be even greater. If they can’t get paid to send the trades to internalizers, Fidelity (and other retail brokers) would likely need to send those retail orders directly to the stock exchanges and, for orders that reduce liquidity in the markets, pay the exchanges a “take fee” under the maker-taker rules.

The disconnect in all of this, though, is that the proposed pilot program is dealing with small-cap stocks only, a mere 2 percent of total market trading volume. The truth of the matter is that any changes in this tiny segment of the market would have NO meaningful impact to retail brokers’ bottom lines. So why all of the fuss over mere peanuts?
Because the opposition to the SEC’s small-cap pilot program isn’t about peanuts. Nor is it about protecting retail investors.

Rather, it’s about not exposing the largely unknown underbelly of payment for order flow in the broader market. If this pilot program invited scrutiny to that practice, the implications would add up to a whole lot more than mere peanuts. Indeed, what’s been happening for nearly 30 years under the big tent of the entire retail brokerage system could be fodder for the lions.

A version of this story originally appeared in Bloomberg.