Betting Against The House: Are SEC Plans To Curb Payment For Order Flow A Good Idea?

It’s played a significant role in the meteoric rise of retail investing brokerages online in recent years, but the days of ‘zero commission’ payment-for-order flow (PFOF) business models for the likes of Robinhood may be numbered as the US Securities and Exchange Commission eyes up a potential ban on the controversial practice. 

After platforms like Robinhood pioneered payment-for-order flow in 2019, we’ve seen an unprecedented number of retail investors arrive on to the market to invest their money in stocks without having to see traditional commission setups eating into their earnings. This is because PFOF sells their order flow to market makers instead - meaning that brokerages still make their money in a less visible manner. 

The approach has drawn derision from Wall Street stalwarts like Warren Buffett, who said that platforms like Robinhood have “become a very significant part of the casino aspect, the casino group, that has joined into the stock market in the last year or year and a half.”

“American corporations have turned out to be a wonderful place for people to put their money and save but they also make terrific gambling chips,” Buffett said at Berkshire Hathaway’s 2021 annual meeting. “If you cater to those gambling chips when people have money in their pocket for the first time and you tell them they can make 30 or 40 or 50 trades a day and you’re not charging them any commission but you’re selling their order flow or whatever...I hope we don’t have more of it.”

(Image: Nasdaq)

However, data suggests that PFOF systems have been wildly successful for retail brokerages since their arrival in late 2019. This, coupled with the Covid-19 pandemic in which investors found themselves with more access to stimulus packages and more spare time to invest in stocks and shares has forged a perfect storm of adoption. 

(Image: CB Insights)

In Robinhood’s recent S-1 filing ahead of going public, the platform disclosed that their monthly active users topped 20 million in the opening months of 2021 - bolstered by the highly publicized short squeeze of GameStop via a mobilized collective of retail investors. 

However, Robinhood’s recent success is now under threat from regulators. As Maxim Manturov, head of investment research at Freedom Finance Europe notes, “SEC Chairman Gary Gensler has stated that his agency is considering a ban on payment for order flow (PFOF), which is the primary source of revenue for Robinhood and many of its competitors. PFOF enables these brokers to eliminate visible transaction fees, which they use as their key marketing tool.”

When news emerged that Gensler had claimed that a ban on payment-for-order flow was ‘on the table’ in late August, it prompted a 9% dip in Robinhood’s stock value from which the popular online brokerage has struggled to overcome. 

But what actually is payment-for-order flow? And is a prospective ban a good idea for the wider world of retail investing? Let’s take a deeper look into the controversial practice that sparked a retail revolution: 

How Does Payment-for-Order-Flow Work?

In a nutshell, brokerage firms that utilize payment for order flow receive money from third parties as a result of directing the orders of their clients to the paying firm’s trading desk. This approach bypasses other market makers and exchanges regardless of the competitive pricing they offer. 

The revenue that’s generated from the payments received for this guaranteed order flow has allowed retail brokerages to eliminate the commissions they charge for online retail trades. 

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It’s worth noting that PFOF is nothing new, although its prevalence across the world of retail investing has grown exponentially since 2019. In these cases, the SEC typically required disclosure of brokerages making such arrangements to customers under the commission’s rule 606. 

In his recent interview with Barron’s, Gensler stated that the SEC’s decision to consider the outlawing of PFOF was fundamentally down to the “inherent conflict of interest” that the practice creates for brokerages in serving their users. 

Could Banning Payment-for-Order Flow Hinder Retail?

Despite Gensler being right to fear the prospect of conflicts of interest in payment-for-order flow models, there’s been a clear backlash against plans to ban the approach across the industry. 

Founder of Unison Advisors and Bloomberg Opinion columnist Nir Kaissar wrote that “Payment for order flow is an indispensable tool in the democratization of markets. Coupled with the ability to buy and sell fractional shares of companies, the practice has made stock investing available to everyone. But it’s under assault, undeservedly so, and needs support.” 

Robinhood joined Kaissar in the backlash, with the company’s chief legal officer Dan Gallagher labelling the idea of banning PFOF “pretty draconian.” 

"This is the revenue that provided us the ability to offer commission-free trading with no minimum balance. Abandoning it would be such a negative thing for retail investors," Gallager explained. 

(Image: Financial Times)

Fundamentally, it’s clear that the arrival of the PFOF model has played a significant role in making investing far more accessible across the retail landscape. Despite ‘zero-commission’ brokerages clearly not being quite as free as they claim to be under a payment-for-order flow setup, it’s emboldened individual investors to deliver record average trading volumes to US stocks. 

With such unprecedented levels of investment democratization taking place, if the SEC were to follow through with plans to ban payment-for-order flow, it could stop an entire new generation of investors in their tracks - leading to more harm done to Wall Street than good.