Speculative activity surrounding the stock of the video game retailer GameStop has been in the news. The Washington Post discussed how the trading platform Robinhood, used by many small investors purchasing GameStop stock, funds itself through payments for order flow rather than fees paid by those who buy or sell the stocks. That is, the orders submitted by the ordinary retail investors that make up Robinhood’s customer base are directed to Citadel, a maker of a trading market for stocks, for execution in return for payments to Robinhood.

Why would Citadel pay for orders? Citadel learns about the supply of and demand for GameStop and then uses that knowledge to inform its automated high‐​speed trading.

Payments for order flow are not new. This 2002 article in Regulation discussed the issue. It argued that payments for order flow are used by brokers to lower commissions, which customers can observe easily, while customers’ ability to ascertain whether the best possible price was obtained in the trade is impossible. Because of investors’ inability to monitor brokerage performance, brokers will compete for investors’ orders not on the basis of trade execution performance but on other dimensions that investors can, and do, form a judgment on, such as commission rates, which in the case of Robinhood are zero. Thus, as of 2002, payments for order flow were fine as long as there was competition among firms that execute stock trades.

More recent scholarship views payments for order flow as an important component of the arms race among High Frequency Traders (HFT). No development in financial markets causes more discussion and disagreement than HFT.

Forty years ago, the “making” of a market in equities was done by monopoly “specialists” who owned seats on exchanges. They were compensated by the “spread”— the difference between the price they offered sellers and charged buyers. Those differences were large enough to more than cover costs. The excess profits were capitalized in the prices that specialists paid for the right to trade on an exchange.

Now liquidity is provided by traders using computers. Many commentators view this change positively because the costs of trading have been dramatically reduced along with the rents to specialists. Bid‐​ask spreads have decreased over time and revenues to market‐​makers have decreased from 1.46 percent of traded face value in 1980 to just 0.11 percent in 2006 and 0.03 percent in 2015. And HFT reduces stock price volatility. When the temporary ban on short sales of financial stocks existed in 2008, the financial stocks with the biggest decline in HFT had the biggest increase in volatility.

But bid‐​ask spreads are larger than they could be because of the “arms race” among HFT participants to locate their servers closer and closer to the servers of electronic exchanges. This arms race exists because the transfer of buy and sell offers from any of the actual computerized exchanges to the National Market System (NMS) takes real‐​time. This creates the possibility of learning about prices at a computerized exchange and trading on that information through the NMS before the NMS posts the information. Traders have responded to these facts by paying to locate their servers in the same location as exchange servers, utilizing the speed of light to arbitrage price differences at the level of thousandths of a second (latency arbitrage).

The arms race is the result of exchanges’ use of “continuous‐​limit‐​order‐​book” design (that is, orders are taken continuously and executed in the order of arrival). In a continuous auction market, someone is always first. In contrast, in a “frequent batch” auction (in which trades are executed, by auction, at stipulated times that can be as little as a fraction of a second apart), the advantage of incremental speed improvements disappears. In order to end the latency arbitrage “arms race,” exchanges should switch to batch auctions.

What are the costs of the arms race? If multiple participants are engaged in a speed race, some will succeed and some will fail. A complete record of London Stock Exchange activity for all stocks in the FTSE 350 index for a 9‐​week period in Fall 2015 found that the “latency arbitrage tax,” defined as latency arbitrage profits divided by all trading volume, is about .5 basis points (.015%). The average bid ask spread (the effective charge for liquidity provision) in the data is just over 3 basis points. Thus, the latency arbitrage tax is about 17% (.5/3). If liquidity providers did not have to bear the adverse selection costs of losing races, the cost of trading would be reduced by 17%. This amounts to 60 million pounds annually on the London Exchange and an estimated $5 billion per year across all global equity markets.

Will exchanges adopt batch trading? The conventional answer is no because they make most of their revenue from charges for the co‐​location of traders’ servers with the exchange servers to allow faster trades. But an important component of the explanation for the lack of adoption of batch trading by exchanges are SEC regulatory requirements.

The main cost an exchange would face in adopting frequent batched auctions would be the cost of obtaining SEC approval. And once the SEC’s approval of a batch market is won, at some significant cost, other participants can free ride on that approval without incurring the legal cost by adopting the same structure themselves.

In addition, the design of a batch auction cannot be patented. As a result, the only way for an exchange to make money through a batch design is a trade secret, but under SEC regulations, exchanges must disclose everything for public comment and subsequent SEC approval.

Alternative Trading Systems (ATSs) are not exchanges and are subject to much less disclosure and regulation than exchanges. ATSs can change their rules more quickly and innovations can remain trade secrets. ATSs just file a form with no notice and comment period and responses.

How important are the regulatory differences? When Intercontinental Exchange (ICE), the owner of the New York Stock Exchange purchased the Chicago Stock Exchange, CHX had trivial volume. ICE was purchasing “an exchange license” for $70 million, which suggests the costs of the formal SEC exchange application rules are quite substantial. When the ATS IEX applied to become a stock exchange in fall 2015 and conduct its trading with a batch design, its application was followed by months of disputes even though its proposed market structure was basically identical to its operation as an ATS. SEC approval took nine months. Two ATSs, OneChronos and IntelligentCross, have adopted batch trading while IEX has not had much success as an exchange.