This article first appeared in the Morning Brief. Get the Morning Brief sent directly to your inbox every Monday to Friday by 6:30 a.m. ET. Subscribe
September 23, 2022
Who else is sick of talking about the Fed? Of course, the Federal Reserve and its battle against inflation using higher interest rates is vitally important. But I need a break.
So, on to another crucial question: Are zero-commission brokerages ripping you off?
The Securities and Exchange Commission is apparently deciding they are not — or at least that the SEC isn't going to do anything about it even if they are. Bloomberg reports the agency has decided not to ban payment for order flow, known as PFOF. That’s a practice in which brokerages process customers’ trades through wholesalers, in a way that critics say saddle individual traders with hidden fees.
The argument against PFOF is that the practice poses a conflict because, in theory, brokerages should be aiming to make money for their customers — not market makers like Citadel Securities. In reality, it's tough to find many in favor of an all-out ban on PFOF aside from meme stock aficionados who populate Twitter and Reddit. Rather than banning PFOF, the SEC would be wise to focus on price transparency and requiring brokers to execute trades at the best price possible at the time.
“The SEC does not have to ban payment for order flow or other specific anti-investor, conflict-ridden market practices if it requires best execution to be the best available price at the time given order characteristics and market conditions," Dennis Kelleher, head of investor advocacy group Better Markets, told Yahoo Finance in an email. "If it does that, the SEC won’t have to play whack-a-mole with an industry that is relentless in creating new wealth extraction practices that avoid yesterday’s rules and require new rules tomorrow."
A crucial revenue stream for commission-free brokerages
In a PFOF model, a commission-free brokerage like Robinhood or Schwab processes an investor’s order for a stock purchase and passes it on to a wholesaler, like Citadel Securities or Virtu Americas. These market makers then execute the transaction and pay brokerage firms for routing the trade through them.
When the market maker can purchase a stock at a lower price than the customer asked for, the brokerage and the market maker split the savings. The money pocketed by the brokerages, the "payment for order flow," can finance its commission-free business.
This an important revenue stream for Robinhood, which popularized the practice in 2020 when US households were flush with stimulus checks and ready to play the market. Since then, trading on Robinhood has declined — along with its stock price — and it has tried to diversify revenue streams.
According to analyst Devin Ryan of JMP Securities, PFOF made up 9% of Robinhood's equities revenue last quarter, 36% of options revenue, and 18% of crypto revenue. Shares of the company surged on the report that the SEC wasn’t planning to institute a ban. However, then Robinhood then erased that gain and closed down 2.72% at $9.65 a share — far less than this time last year, when it was trading for five time as much.
Still, it's clear the Bloomberg report on the SEC's decision regarding PFOF is good for Robinhood. Is that gain coming at the expense of small investors?
Trading firms, predictably, think there’s no issue with the current system, and argue that retail traders already get good prices. SEC Chair Gary Gensler has largely taken the other side, saying in June that payment for order flow “can distort routing decisions.”
However, experts argue that eliminating PFOF would attack the wrong issue. The problem, according to one recent study by several business school professors, is the wildly different prices retail investors can pay depending on which market maker routes their orders. That study found that differences among brokerage platforms and where an order is routed can cost small investors up to $34 billion a year.
The solution to that problem isn't to get rid of PFOF, according to Christopher Schwarz, a professor at the University of California Irvine, who co-authored that study. Instead, he said, brokerages should be more transparent about prices.
The debate over banning PFOF “is the shiny thing in the room that is distracting everyone from the issue of market centers giving very different execution to different brokers. And that execution is not related to PFOF," Schwarz wrote Yahoo Finance on Thursday.
Jared Dillian, editor and publisher of the Daily Dirtnap and investment strategist at Mauldin Economics, argued last month for Bloomberg Opinion that regulation of PFOF could backfire.
"The US has the deepest, most liquid capital markets in the world, but we might not if regulators start getting too involved," he wrote. "As long as competition exists, things will get better and trading costs will come down even further.”
Undoubtedly, many on Wall Street agree with Dillian, and papers like those from Schwarz may have swayed the SEC to look at the issue differently. Of course, the agency might end up banning PFOF or restricting it. In the meantime, it's tough to say whether investors are mad at PFOF or just wary of the market these days.
The number of people trading via Robinhood has fallen this year, to 14 million monthly transacting users by June 2022 from 17.3 million last December. As Robinhood's user base has shrink, alternatives have cropped up — including Public.com, which is commission-free, doesn’t offer payment for order flow, and allows users instead to offer a tip to brokers that execute their trades. The company says its users grew from 1 million in mid-2021 to 3 million in early 2022.
Ultimately, PFOF might fall out of favor, regardless of whether the SEC steps in to police the practice.
What to Watch Today
9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, September Preliminary (51.1 expected, 51.5 during prior month)
9:45 a.m. ET: S&P Global U.S. Services PMI, September Preliminary (45.0 expected, 43.7 during prior month)
9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, September Preliminary (46.0 expected, 44.6 during prior month)