NYSE President: Stocks Favored by Retail Lack Accurate Price Action

In a conference hosted by CNBC, the president of the New York Stock Exchange Stacey Cunningham asserted that the prices on exchanges of alleged “meme stocks” may not be commensurate to their actual value. She blamed the controversial payment for order flow (PFOF) arrangement as the cause for such polarities. 

Cunningham: Meme Stock Prices May Be Distorted

“Meme stocks” are heavily shorted stocks with high trading volume that undergo dramatic price hikes in a relatively short period of time. Such surges are mostly fuelled by retail traders—as we can see with AMC, which retails traders own at least 80%.

GME tends to fall under this umbrella term, despite generating $1.3 billion in Q1 2021 revenue. While not every stock that surges in a short period is necessarily a “meme stock”, the term has now gone viral — used for almost any stock that is supported by retailers. According to Cunningham, retail investors contribute as much as 70% in meme stocks. But, why would that be a problem?

Cunningham states that the majority of retail orders are executed away from public exchanges, which creates a price formation that is not “really” reflective of what supply and demand is.

She stated:

“In some of the meme stocks that we’ve seen, or stocks that have a high level of retail participation, the vast majority of order flow can trade off of exchanges, which is problematic.”

While everything she asserts may seem to be reasonable, it turns out to be quite contentious when focusing on the core problem: order flow that takes place off exchanges. This happens because of an arrangement called payment for order flow. Following a study by the SEC, the commission defined ‘payment for order flow’ as:

“… a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”

From a broad perspective, when this definition is combined with the dubious fact that order flow reduces overall costs for individual traders is exactly why this arrangement was created in the first place. However, that doesn’t mean the practice—which is banned in Canada and the U.K.—doesn’t come without controversy.

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Why is Payment for Order Flow Problematic?

Payment for order flow (PFOF) is a model that provides commission-free trades to users, where the broker funnels orders to different market makers for trade execution. Since equity and options trading has become increasingly complex with the proliferation of exchanges, a smaller brokerage firm that can’t handle thousands of orders can use the PFOF arrangement to both save costs and receive compensation.

However, this naturally invites a conflict of interest—and this is where the problem arises. PFOF can be used to route orders to market makers that not only disregard the best interest of investors, but exploit investors. In other words, PFOF arrangements create a structure that market makers take advantage of. In the U.S., regulatory agencies are finally providing public recognition of this.

Indeed, it is for this “conflicts of interest” that the UK Financial Services Authority (FSA) banned PFOF arrangements in 2012. Simultaneously, Canada has also banned PFOF for the same reason, yet the SEC was satisfied with requiring brokers to disclose their policies surrounding this practice — up until recently.

As part of the U.S House Financial Services Committee’s third GameStop hearing, new SEC Chairman Gary Gensler also mentioned the issue with PFOF practice.

While implying that PFOF could eventually see a ban in the U.S., Gensler said:

“We found conflict in various enforcement cases like one we filed where the wholesaler was literally saying, ‘Well you tell me. I can pay you more — the broker — or I can pay the customer more.’ We know at least from that case this inherent conflict is there.”

Do you think “meme stocks” will be a new term for every stock that is supported by retail investors? Considering all the controversies surrounding PFOF, why do you think the US has not banned it yet? Let us know in the comments below.