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January 1, 1998

Is the Payment for Order Flow Stream Drying Up?Nasdaq Dealer Says Rebates Have Been Halved on Ove

By Michael L. O'Reilly

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  • Is the Payment for Order Flow Stream Drying Up?Nasdaq Dealer Says Rebates Have Been Halved on Ove
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Payment for order flow on Nasdaq business could soon be facing extinction. The profit on each Nasdaq trade, which once enabled a market maker to pay an order-entry firm around two cents a share for order flow, has shrunk threatening the rebates vital to some discount brokers.

"Payments have been cut about 50 percent across the full range of orders," said Leonard Mayer, president of New York-based Mayer & Schweitzer, a Charles Schwab Corporation affiliate and leading Nasdaq market maker.

"Quite honestly, I think payment for order flow on Nasdaq business will soon be a thing of the past," said Tom Dudenhoefer, head of Nasdaq trading at St. Petersburg-based Raymond James & Associates.

But while a cut in half may seem significant, Mayer contends that payment on marketable orders orders that enable the dealer to profit on the spread is not down as significantly.

One industry expert said that while payments on limit orders are down dramatically, payments for marketable orders are still close to historical levels. In fact, the 50 percent reduction does not reflect a cut in all payments, but mostly the dramatic drop in limit-order payment, the expert added.

Mayer said his firm no longer pays for limit orders, because the vast majority do not offer the opportunity to make a profit. The firm will continue to pay for marketable orders.

"Mayer & Schweitzer does not pay for limit orders anymore," Mayer added. "And I would say that generally, market makers have ended the practice of paying for limit-order flow."

Jerry Kasten, a specialist on the Boston Stock Exchange for Garden State Securities,

agrees. "Nobody pays for limit orders because no money can be made," he said.

Kasten added that payment for pure market orders on strong stocks remains close to normal levels, with rebates around two cents a share. But payments for less stable stocks has dropped to below a penny, he said.

The Practice

A payment-for-order-flow arrangement is typically forged between a discount order-entry firm and a broker dealer. Generally, it refers to the payment of cash by dealer firms to brokerages to induce them to send aggregated small orders to purchase or sell securities to the dealers for execution.

Often, it is discount firms that enter into the order arrangements to subsidize their low commissions with the fees from broker dealers typically a penny or two a share.

Payment for order flow has long been a controversial part of Wall Street trading. A broker's fiduciary duty is to obtain the best possible execution for a customer's order. But the obvious temptation is to send orders to the market maker offering the highest rebate, regardless of best execution.

But last year, the practice survived a Supreme Court challenge, and the Securities and Exchange Commission has ignored frequent requests to ban the arrangements.

"There is very little in the securities industry that does not involve some sort of back scratching," said Andrew Davis, a Chicago Stock Exchange (CSE) specialist for Rock Island Securities. "Payment for order flow is a valid and well-regulated part of the business. With a lot of other types of deals, the customer never really finds out what is going on."