What is Payment for Order Flow? - Part Two
THE ETERNAL PROBLEM OF TRANSPARENCY
The only consensus that has emerged from this fractiousdebate is that it is impossible to eliminate payment for order flow in theoptions markets. “Any time there are multiple manufacturers trying to sellproduct down a limited number of distribution channels, there are going to beincentives offered,” says Kenneth Leibler, Chairman of the Boston OptionsExchange. “I don’t think that you will ever eliminate these incentives.” Frucher agrees, saying, “you’re never going toeliminate payment. What you really have to do is define it, control it and makesure it’s transparent.”
The issue of transparency has become especially problematicin recent years. Many firms and exchanges are adept at disguising theincentives that they provide to brokerage firms. Payments of cash arefrequently compounded with other, less obvious incentives. One popular methodis to allow the brokerage house to cross, or internalize, a larger percentageof their volume. This allows the brokerages to gain double commissions andgenerate position profits without any cash changing hands.
The combination ofinternalization with direct payment has prevented the SEC from issuing a rulingon payment for order flow. “Part of the problem is that the SEC has been unableto differentiate these different things sufficiently,” says Brodsky. “ Assomeone who has been in the business a long time, the difference betweentickets to a ballgame, or internalization, or a direct payment, one may be moreobvious than another, but the SEC has recognized, at least from thatperspective, that they can’t sort these out.
JUST ONE MORE BLACK EYEThe continuing debate over payment for order flow has tarnished thereputation of the entire options industry. “The finger gets pointed atthe options industry as though it were the only one that does paymentfor order flow and that it has been eliminated by pennies in the equityindustry,” says Frucher. “That’s just not true. Virtually every orderthat is sent to ARCA or the NASDAQ is an order that is paid for in oneform or another.”
Whether you agree with payment for order flow or not, you have to admitthat brokerage firms accepting cash payments in return for orders is ablack eye for the entire industry. Options have long been depicted asarcane shadow markets by the mainstream financial media. The last thingthat this industry needs is another embarrassing scandal that shakesthe trust of the investing public.
The onus is on the SEC to put an endto this ongoing debacle. If they decided to refuse incentive payments,then there would be no more debate. Unfortunately, they aren’t likelyto turn off the cash spigot anytime soon. At the end of the day, itlooks like the only hope for ending this practice lies with the SEC.Unfortunately, given their dismal track record with the derivativesregulation, I’m not holding my breath.
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