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September 23, 2022
Who is tired of talking about the Fed? Of course, the Federal Reserve and its fight against inflation through higher interest rates is crucial. But I need a break.
So, moving on to another crucial question: Are you being ripped off by no-commission brokerage deals?
The Securities and Exchange Commission apparently decides they aren’t — or at least that the SEC won’t do anything about it even if they are. Bloomberg reports The agency has decided not to ban payment for order flow, known as PFOF. It’s a practice whereby brokers route clients’ trades through wholesalers, in a way that critics say charges individual traders hidden fees.
The argument against PFOF is that the practice is conflicting, as brokerage firms should, in theory, aim to make money for their clients – not market makers like Citadel Securities. In reality, it’s difficult to find many in favor of a blanket ban on PFOF, apart from the meme-stock lovers who crowd Twitter and Reddit. Instead of banning PFOF, the SEC would be wise to focus on price transparency and require brokers to execute trades at the best possible price.
“The SEC need not prohibit payment for order flow or other specific investor-hostile, conflict-ridden market practices if it requires best execution to be the best available price at the time given order characteristics and market conditions,” Investor Advocacy Director Dennis Kelleher better markets, Yahoo Finance said in an email. “By doing so, the SEC won’t have to toy with an industry that relentlessly invents new wealth-gaining practices that circumvent yesterday’s rules and require new rules tomorrow.”
A crucial source of income for commission-free referrals
In a PFOF model, commission-free mediation such as Robin Hood or Schwab processes an investor’s stock purchase order and routes it to a wholesaler such as Citadel Securities or Virtu Americas. These market makers then execute the transaction and pay brokerage firms to route the trade through them.
If the market maker can buy a stock at a lower price than the client asked for, the brokerage firm and the market maker split the savings. The money brokers pocket, the “order flow payment,” can fund their commission-free business.
This is a key revenue stream for Robinhood, which popularized the practice in 2020 when US households were flush with stimulus checks and poised to gamble in the market. Since then, trading in Robinhood has declined — along with its stock price — and attempts have been made to diversify revenue streams.
According to analyst Devin Ryan of JMP Securities, PFOF accounted for 9% of Robinhood’s stock revenue, 36% of option revenue, and 18% of crypto revenue last quarter. The company’s shares rose on the report that the SEC has no plans to impose a ban. Then, however, Robinhood erased that gain, closing up 2.72% at $9.65 a share — far down from this time last year, when it was trading for five times that much.
Still, it’s clear that the Bloomberg report on the SEC’s decision on PFOF is good for Robinhood. Is this gain at the expense of small investors?
Retailers, as expected, think there is no problem with the current system and argue that retailers are already getting good prices. SEC Chairman Gary Gensler has largely taken the other side, saying in June that the order flow payment “can skew routing decisions.”
However, experts argue that eliminating PFOF would address the wrong problem. the problem according to a recent study by several business school professors, are the vastly different prices retail investors can pay depending on which market maker routes their orders. This study found that differences between brokerage platforms and where an order is routed can cost retail investors as much as $34 billion per year.
The solution to this problem is not getting rid of PFOF, according to Christopher Schwarz, a professor at the University of California Irvine who is a co-author of this study. Instead, he said, brokers should be more transparent about prices.
The debate about banning PFOF “is the shiny thing in the room that distracts everyone from the issue of market centers giving very different explanations to different brokers. And this execution has nothing to do with PFOF,” Schwarz wrote to Yahoo Finance on Thursday.
Jared Dillian, editor and editor of the Daily Dirtnap and investment strategist at Mauldin Economics, argued for Bloomberg Opinion last month Regulating PFOF could backfire.
“The US has the deepest and most liquid capital markets in the world, but maybe not if regulators get too involved,” he wrote. “As long as there is competition, things will get better and the cost of trading will continue to fall.”
No doubt many on Wall Street agree with Dillian, and papers like Schwarz’s may have persuaded the SEC to look at the issue differently. Of course, the agency could end up banning or restricting PFOF. In the meantime, it’s hard to tell if investors are mad at PFOF these days or just skeptical of the market.
The number of people trading through Robinhood has dropped this year from 17.3 million last December to 14 million monthly trading users by June 2022. As Robinhood’s user base has shrunk, alternatives have emerged — including Public.com, which is commission-free, offers no payment for order flow, and instead allows users to tip brokers who execute their trades. The company says its users have grown from 1 million in mid-2021 to 3 million in early 2022.
Ultimately, PFOF could fall out of favor regardless of whether the SEC steps in to oversee the practice.
What to see today
9:45 a.m. ET: S&P Global US Manufacturing PMISeptember Prelim (51.1 expected, 51.5 last month)
9:45 a.m. ET: S&P Global US Services PMISeptember Prelim (45.0 expected, 43.7 in previous month)
9:45 a.m. ET: S&P Global US Manufacturing PMISeptember Prelim (46.0 expected, 44.6 in previous month)