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Robinhood, the uber-popular brokerage, helped usher in a new era of commission-free trading. It pushed established financial institutions, such as Charles Schwab and Fidelity, to follow suit.
Sadly, there’s no such thing as a free lunch. In a world of commission-free trading, brokers still had to make money on their clients’ trades somehow. One of the most lucrative—and controversial—options is a practice called payment for order flow.
“Payment for order flow enables commission-free trading,” said Robinhood chief executive Vlad Tenev during Congressional testimony in February 2021 following the Gamestop debacle.
While everyday traders love zero commissions, the practice is controversial with government regulators. They claim it can lead to suboptimal execution prices on trades and conflicts of interest for brokers.
The Securities and Exchange Commission (SEC) fined Robinhood $65 million in late 2020 for routing trades to market makers that didn’t offer the highest price, and also for misleading its customers as to what was going on.
The issue isn’t going away anytime soon. The SEC is investigating a handful of potential reforms that could change or even eliminate payment for order flow.
What form those new rules take, and how popular they prove with retail investors, remains to be seen.
What Is Payment for Order Flow?
It used to be very expensive to play the stock market.
Remember the Dot Com bubble in the late 1990s? In order to buy and sell shares of Pets.com, investors were typically paying commissions of around $40 per trade. Back in the early 1980s, an average investor might have to pay a $200 commission on a stock trade.
More recently, fierce competition among discount brokers pushed trading commissions steadily lower. By the late 2010s, many brokers had eliminated training fees altogether.
Of course, these companies aren’t operating charities. They turned to payment for order flow to generate revenue.
When an investor submits an order to buy or sell a stock, their broker passes the order along to a third party to execute the trade and perform the transaction.
This third party is known as a market maker and are large financial institutions, such as Citadel Securities, that provide liquidity to the market by both buying and selling securities.
The market maker pays the brokerage a small commission to fill the customer’s order. Since the market maker is both buying and selling stocks and other securities, it can set its own purchase and sales price.
A market maker buys shares of stock at a lower price than the price at which it sells shares, a difference known as the bid-ask spread.
How Does Payment for Order Flow Work?
The more order flow the market makers receive from the likes of Robinhood, the more profit they can generate from the bid-ask spread. Brokerages earn more when they send more trades to the market makers.
Let’s say a market maker purchased 100 shares of Apple (AAPL) stock from a retail seller for $152.01 per share, and then turned around and sold the stock to a retail buyer at a price of $152.04 per share.
In this example, the market maker would make only a $0.03 profit on the orders, but market makers process millions of orders a day.
In fact, one of the biggest motivations behind zero-commission trades is to encourage more active trading by retail traders so brokerages have more order flow to sell. To wit: Robinhood’s exploding confetti and gamification.
And business is booming. The 12 largest U.S. brokerages earned a total of $3.8 billion in payment for order flow revenue in 2021, per Bloomberg Intelligence, a 33% jump from the year prior. Robinhood alone took in $974 million, or about half of its total revenue for the year.
Criticism of Payment for Order Flow
Customers don’t pay to execute trades, and brokerages out like bandits…so what’s the issue? One potential problem with payment for order flow arises from the prices at which retail trades are being executed.
The SEC oversees broker execution standards and guards against actions that might disadvantage investors, including offering misleading information.
This was at the crux of the 2020 Robinhood settlement.
“Robinhood failed to seek to obtain the best reasonably available terms when executing customers’ orders, causing customers to lose tens of millions of dollars,” said Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit.
According to the SEC, Robinhood sold order flow to the market maker that gave it the best rebate rather than the one that offered the best price for Robinhood’s clients.
Meanwhile the Financial Industry Regulatory Authority (FINRA) conducts examinations and audits to ensure brokers are meeting best execution standards.
According to FINRA Rule 5310, brokers must use “reasonable diligence” to determine the best market for a security and execute orders at a price that is “as favorable as possible under prevailing market conditions.” The rule is meant to reduce conflicts of interest.
Regulators Are Taking a Hard Look at Payment for Order Flow
Regulations governing payment for order flow may soon be strengthened.
In June, SEC chair Gary Gensler said it was one of several areas the SEC is investigating to identify potential changes to market structure to make things more fair and transparent for retail traders.
“Payment for order flow can raise real issues around conflicts of interest,” said Gensler. “Certain principal trading firms seeking to attract Robinhood’s order flow told them that there was a tradeoff between payment for order flow and price improvement for customers.”
The SEC is currently looking into a system of open and transparent public auctions for order flow that could serve as an alternative to the practice, and has also proposed creating its own best execution rule for equities and other securities that could further clarify the brokers’ pricing responsibilities.
The SEC is also exploring how to mitigate conflicts of interest, and considering ways to improve transparency by providing a way for retail investors to compare execution quality on a broker-by-broker basis to determine which brokers are filling orders at the best prices.
Will Payment for Order Flow Be Banned?
While there is a lot of smoke at the moment, equity market structure reform is still in the very early stages, said Bank of America managing director Craig Siegenthaler.
He pointed out that SEC chair Gensler was far from clear about the future of payment for order flow and wouldn’t say an outright ban is being considered.
Jamie Cox, financial advisor at Harris Financial Group, agrees.
“The SEC is going to have its hands full with oversight hearings in the next Congress, and that will backburner this issue,” Cox said. “The SEC will stick with less politically sensitive subjects like stablecoins, crypto and failures to archive electronic messaging.”
The topic of whether payment for order is good or bad for retail traders isn’t an easy question to answer, as well as being politically charged.
Dennis Dick, a retail trader and market structure analyst at Triple D trading, expects the SEC to chart a middle bath; focus on increasing disclosure of how retail orders are being handled, rather than eliminating payment for order flow out of fear of increasing commission costs.
Right now, the SEC is still in the ideas phase, and there’s no timeline when the commission will conclude its research.
Even if the SEC implements new rules, there would first be a period of public debate and comment before anything is implemented.