Gensler SEC may scrutinize payment for order flow, Schwab says

As Gary Gensler’s expected confirmation as head of the SEC approaches, Charles Schwab is gearing up for his impending regulatory agenda, and in particular, how the regulator may handle payment for order flow.

It’s yet another revenue stream that may face pressure at Schwab, and throughout the industry, after the company spawned a race to zero commissions more than a year ago among competitors.

Recent swings of stocks including GameStop have renewed regulators’ attention to trade settlement, market manipulation through social media and short selling disclosures, says Christopher Gilkerson, chief legal officer and general counsel of Schwab, who spoke with reporters March 30. The hype over “meme stocks” also has invigorated the SEC’s interest in payment for order flow.

There was “an implication that eliminating online commissions for retail investors has been bad, because broker-dealers collect payment for order flow, allegedly at the expense of best execution for client orders,” Gilkerson says.

Payment for order flow is a commonplace, and controversial, practice among broker-dealers across both the retail investing and wealth management industries. Market makers pay broker-dealers small rebates — typically fractions of pennies — to send them client orders for execution.

Because market makers can offer liquidity as well as price improvement over the national best bid and offer at exchanges, many broker-dealers say the practice is lucrative for all parties, and especially clients. However, some companies don't take these rebates and hand them down to clients in terms of further price improvement.

The practice of payment for order flow is complicated, and it’s been criticized and evaluated for years, particularly after Michael Lewis’ book Flash Boys was published in 2014.

The GameStop debacle ignited conspiracy theories of foul play, with members of Congress joining in the finger-pointing, though broker-dealers said there was an evident, albeit complicated, reason they temporarily restricted trading of certain stocks.

The retail brokerage Public subsequently announced it would stop accepting rebates from market makers and start routing its orders directly to exchanges.

Schwab anticipates that a Gensler SEC will conduct research on the matter of payment for order flow, according to Gilkerson.

“As a result of GameStop and the questioning at that Senate Banking Committee hearing, I'd expect Gensler, as chair of the SEC, will undertake an extensive study of the issue,” Gilkerson says. That may include a roundtable request or comments on proposed rulemaking, he added.

Schwab “will be very active” throughout the process to advocate for advisors and their clients, he says, emphasizing that Schwab is adamant about guaranteeing best execution.

“Outstanding execution quality is a top priority with or without payment for order flow,” says Gilkerson.

When pressed as to whether Schwab would take a second look at these payments, Gilkerson said that, at this point, Schwab is “continuing our business practices. They’re transparent. They’re disclosed.” However, he noted that the company “will continue to evaluate things as the industry discussion and the conversation with the SEC moves forward.”

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Payment for order flow is a small, but meaningful, revenue generator at Schwab. The company received $621 million in order flow revenue in 2020, approximately 6% of its net revenue, according to its annual report. That number was higher than it typically would be, given the unprecedented market volumes (order routing revenue at Schwab was only 1% of net revenue in both 2018 and 2019).

The company said clients benefitted from this approach. Schwab’s execution methods saved its clients approximately $598 million in price improvement on their equity and option orders in the last three months of 2020 alone, according to the firm.

Executives had mentioned in the company’s annual meeting that, following the TD Ameritrade integration, the company may experience a slight order flow revenue boost, should there not be any changes to the market structure.

“We're going to remain focused on making sure our clients get great execution, regardless of what happens there,” Joe Martinetto, the COO in charge of carrying out the Schwab-TD integration, said on the webinar, hosted at the end of February.

As for advisors, it’s important they pay attention to such issues like execution quality, according to Gilkerson.

“They have their own fiduciary obligation to make sure they're seeking best execution on behalf of their clients, and they obviously have to do that through their broker-dealers,” Gilkerson says. Best execution and price improvement, “whether that's through an industry practice that is payment for order flow or as the market structure evolves, that will be our focus.”

Schwab closed the acquisition of TD Ameritrade in early October 2020. Since then, it has laid off more than 1,000 employees. None of the terminations were among its advisor service staff, according to company executives, who reiterated the company will maintain TD Ameritrade’s two institutional servicing locations, in San Diego and Southlake, Texas.