A controversial practice that has brought in billions of dollars to brokers and high-frequency trading firms is in the crosshairs of the Securities and Exchange Commission, and could be eliminated entirely.
In an interview with Barron’s on Monday, SEC Chairman Gary Gensler said that a full ban of payment for order flow is “on the table.” Payment for order flow is a practice where brokers send trade orders to market makers that execute those trades in return for a portion of the profits.
Gensler says the practice has “an inherent conflict of interest.” Market makers make a small spread on each trade, but that’s not all they get, he said.
“They get the data, they get the first look, they get to match off buyers and sellers out of that order flow,” he said. “That may not be the most efficient markets for the 2020s.”
He didn’t say whether the agency has found instances where the conflicts of interests resulted in harm to investors. SEC staff is reviewing the practice and could come out with proposals in the coming months.
Gensler has mentioned several times that the U.K., Australia, and Canada forbid payment for order flow. Asked if he raises those examples because a ban could also happen in the U.S., he replied: “I’m raising this because it’s on the table. This is very clear.”
It’s not the only thing the SEC is considering.
“Also on the table is how do we move more of this market to transparency,” he said. “Transparency benefits competition, and efficiency of markets. Transparency benefits investors.”
Payment for order is part of a larger issue with market structure that Gensler is trying to solve. He notes that about half of trading is in dark pools or is internalized by companies that keep those trades off exchanges. Even some of the trading that takes place on exchanges is opaque — and exchanges are paid through rebates that are similar to payment for order flow. Opaque markets where different investors have their trade orders processed differently have the potential for abuse.
“It provides an opportunity for the market maker to make more, and for ultimately the investing public to get a little less when they sell, or have to pay more when they buy,” he said. “I think it also affects companies raising money,” he added, because it could be a barrier to “fair, orderly and efficient markets.”
The changes to payment for order flow may take place as part of a larger reshuffling of how trades are processed and tracked.
There has been a boom in retail trading in the past two years, with millions of new investors signing on to brokerage apps to trade stocks, options, and cryptocurrencies for the first time. The boom has been driven in part by a change in the way that brokers make money on customer trading. Most brokers no longer charge for trades up front. They make money off trades by sending orders to market makers like high-frequency trading firms. The market maker executes the trade, and profits off the difference between the bid and asking prices, sending part of that profit back to the broker.
For most brokers, the practice is a relatively small part of their business model — often less than 10% of revenue. But for Robinhood Markets (ticker: HOOD), which pioneered zero-commission trading, payment for order flow makes up about 80% of its revenue.
Shares of Robinhood were already trading lower on the day, but fell further after the Barron’s report. In late afternoon trading on Monday, the stock was down 8%, at $43.03.
The company has told investors in securities filings that the SEC’s focus on payment for order flow is a risk factor. But company executives have played down the possibility of it being banned. “Our view internally is that we don’t expect payment for order flow to be banned,” said CFO Jason Warnick on Robinhood’s latest earnings call. He added that “we do think because payment for order flow is such a small revenue stream — it’s about 2 to 2 and a half cents per $100 traded — that it’s not a terribly difficult revenue stream for us to replace.”
But the SEC has found that all those fractions of pennies add up. In fact, the agency settled allegations with Robinhood last year over how it negotiated payment for order flow, and its disclosures to customers. The agency said that Robinhood made deals from 2015 to 2018 with market makers that gave the company a much higher percentage of the spread, whereas other brokers generally gave more of the spread back to customers.
The SEC order said Robinhood had negotiated an 80/20 split, with the company receiving the 80% and investors receiving 20%, whereas other brokers tended to have a split closer to 20/80. And the regulator said that Robinhood’s trade execution was so bad for consumers that it more than outweighed the benefit they got from not having to pay a commission. To settle the allegations, Robinhood agreed to pay $65 million but neither admitted nor denied the findings. The company has also said it has changed its payment for order flow practices.
Proponents of payment for order flow say that it is a way for brokers to make money that doesn’t really hurt consumers, and allow apps to charge zero commissions. It is a major reason that more people than ever have started investing, Robinhood’s Warnick said.
“Never before has investing in this country been cheaper,” he said.
He also noted that other brokers had historically accepted payment for order flow on top of commissions, whereas Robinhood has never charged commissions.
Any change to the practice would clearly be contentious.
“We’ll be definitely defending our customers and making sure that we don’t put up barriers that have been taken down and kept people out,” Warnick said.
Write to Avi Salzman at [email protected]