It’s all about the meme stocks lately.

Gamestop (GME) being the one that really opened eyes to what was a new phenomenon in the stock market…small account retail traders banding together to push back against the big hedge funds.

And since then, it hasn’t slowed down one bit with AMC rocketing to over $70 at the beginning of the month and CLOV spike to nearly $30 a few days ago, among many other names talked about in the Reddit community.

But something that is often forgotten…

None of this would likely be happening without the rise of zero commission trading accounts.

A big part of those trades taking off is people being able buy and sell small numbers of shares quickly without any upfront cost, allowing big groups of small account retail traders to band together and push these stocks to new heights.

On the surface, no commissions sounds great. But there’s actually quite a bit of controversy surrounding it all.

So the question still exists….Is it good or bad?

Payment For Order Flow

This is the system Robinhood used to revolutionize trading for the small investor.

Unheard of up until then, Robinhood came out with commission free trades.

At first it seemed like there was no way they would be able to stick around without charging commissions.

After all, where would their profits come from?

Enter payment for order flow.

What’s that?

Basically… a brokerage firm, instead of sending orders through the exchanges, directs orders to a particular market maker for trade execution…and receives compensation for doing so.

The system helps brokers make enough money on the back-end so they can more easily charge zero commissions for trades.

This is how Robinhood gained popularity with retail investors and changed the industry along the way.

As other brokers have followed suit, being charged commissions is now a thing of the past for most regular retail brokerage accounts.

It all seems simple enough…brokerages get paid by the market makers and traders get zero commissions.

Win, Win right?

Well not so fast…

The Controversy

In a recent analysis… Hitesh Mittal, the founder of BestEx Research, found that the top five market makers seem to get 24.5% price improvement for retail investors’ trades, compared to the National Best Bid and Offer (NBBO) prices on exchanges.

Which seems great for everyone… but Mittal also found that those trades would get even better prices if the retail trades were all done through exchanges.

Mittal’s analysis in “The Good, The Bad & The Ugly of Payment for Order Flow”  shows that overall spreads on trades could drop by 25% if all trades were moved to exchanges.

So Robinhood and other brokers argue that they are offering price improvement with payment or order flow.

The problem is that they are comparing executions to the NBBO on the exchanges and don’t take into account what spreads would be if all trades were sent to the exchanges.

Another question is oversight, what if the broker selects a wholesaler because it pays more rather than because it executes trades at the best price for the retail customer?

If you remember the trouble Robinhood got into just a while back…the SEC found that they had been cutting deals with market makers that were bad for their customers… (They have since  changed their practices to fix the issues).

What’s Next?

Just this week…Gary Gensler, chair of the SEC, said that they will be reviewing payment for order flow and there could be amendments to the current market structure rules.

The way things are now, brokers would be at a competitive disadvantage if they stopped using it.

And this is why the SEC is looking into it… it’s a regulatory issue.

They won’t be the first to question it however… Market regulators in the U.K., Australia, and Canada have all stepped in and banned payment for order flow.

And this brings us full circle to the meme stock phenomenon.

Without the payment for order flow structure, it’s unlikely that brokers could sustain a zero commission model.

And if commissions came back, that could affect the volume in meme stock trades as those trades partly rely on the ability to buy and sell small numbers of shares quickly without any upfront cost.

I don’t know what the SEC will end up doing, but it’s something to keep an eye on as it could affect the zero commission model.

It’s worth noting that the payment for order flow structure has been around for a long time and it’s been investigated in the past…yet always allowed to continue for a number of reasons.

It would also be hard to stop the movement of a zero commission trading industry. Retail traders wouldn’t be happy at all…so speculating here, but most likely the SEC will just look to add more structure and oversight, or more open reporting from the parties involved.

We’ll see…