From the Department of, “About F%$#ing Time”

It looks like the SEC is looking at targeting payment for order flow in stock trades.

The short version is that “market makers” pay retail brokers to funnel their trades through them.

This tactic was developed by Bernie Madoff. Yes, that Bernie Madoff.

This technique, which is one part front running, the market makers execute their own trades ahead of the orders sent to them, and one part anti-competitive behavior, because these market makers can increase the bid-ask spread without the customer knowing that they are getting the shaft.

A portion of these ill-gotten gains go back to the broker as a kick-back for not acting in their clients’ best interest.

What the SEC, more specifically SEC Chairman Gary Gensler, is suggesting is not a ban on the service, but to require that brokerages use a bid process to select the best trading to execute a trade.

This would be a change from the current standard, “reasonable diligence,” which basically means that so long as you are not caught on tape crowing over deliberately screwing clients, everything is OK:

The Securities and Exchange Commission is preparing to propose major changes to the stock market’s plumbing as soon as this fall.

Chairman Gary Gensler directed SEC staff last year to explore ways to make the stock market more efficient for small investors and public companies. While aspects of the effort are in varying stages of development, one idea that has gained traction is to require brokerages to send most individual investors’ orders to be routed into auctions where trading firms compete to execute them, people familiar with the matter said.

………

The most consequential change being discussed would affect the way trades are handled after an investor places a so-called market order with a broker to buy or sell a stock. Market orders, which account for the majority of individual investors’ trades, don’t specify a minimum or maximum price the investor is willing to pay.

Mr. Gensler has said he wants to ensure that brokers execute orders at the best possible price for investors — the highest price for when an investor is selling, or the lowest price if they are buying.

Current rules require brokers to perform “reasonable diligence” to determine the likely best market for executing a trade. Many brokers route orders to big electronic trading firms called wholesalers, including Citadel Securities or Virtu Financial Inc. rather than to exchanges such as the Nasdaq Stock Market, arguing that the wholesalers provide the best prices.

Some brokers, including Charles Schwab Corp. and Robinhood Markets Inc.,accept compensation from wholesalers for routing trades to their venues. Mr. Gensler has said this practice, known as payment for order flow, creates a conflict of interest and limits competition for individual orders.

Under the auctions being considered by the SEC, different firms would compete with each other to fill an individual investor’s trade, according to people familiar with the agency’s plans. Such a mechanism would fundamentally alter the business model of wholesalers, which can make more money by trading against small investors than they do on public exchanges, where they might find themselves trading with other sophisticated trading firms or institutional investors.

(Emphasis mine)

Basically, the wholesalers are making money, and paying kick-backs to brokers, in order to get access to unsophisticated investors so that they can make money by executing on private exchanges (dark pools) to extract money.

………

After a year of internal deliberations, the agency has homed in on a narrowing set of proposals. If the SEC votes to release them for public comment later this year, they would have a path to implementation, as Democrats hold a majority of seats on the commission.

I’m not a fan of Paul Volker, but when the late Federal Reserve Chairman said in 2009 that, “The only thing useful banks have invented in 20 years is the ATM,” he was generally accurate, ATMs had actually been invented about 40 years ago, but his comment on financial innovation was spot on.

Financial innovation is primarily a way to extract rents from the productive parts of society.