Earlier this week, SEC Chairman Gary Gensler offered his tacit approval to a ban on a practice that could have big implications, not only new-age trading platforms such as Robinhood (HOOD) , but also for many of these platforms' most popularly traded stocks.
This practice, known as "payment for order flow" has been a boon to broker-dealers and, in many ways, has helped ignite the "meme stocks" that have attracted so much of the market's collective attention this year.
For perspective on this rise in importance, a recent congressional report stated that payment for order flow to firms such as Citadel Securities and Susquehanna International Group resulted in $2.5 billion in revenue for major broker dealers like Charles Schwab (SCHW) , Robinhood, and E*Trade from 2019 to 2020. Schwab alone saw its ratio of commission revenues to order flow revenue jump from about a 4 to 1 in 2019 to a 1.1 to 1 ratio in 2020, per its latest 10-K filing.
The important aspect for investors in these firms is the fact that both Congress and the SEC are mindful of these trends and are now talking openly about taking action. As such, the practice's rapid rise in importance for brokerages could ultimately backfire.
The Problem With Payment for Order Flow
Payment for order flow (PFOF) is by no means a newly controversial practice. In fact, numerous reports and academic papers dating back decades have derided the, until recently, somewhat obscure practice.
The two sides of the deal in PFOF are the market makers, like Susquehanna and Citadel Securities, and broker-dealers, like Robinhood and Schwab. In this arrangement, broker-dealers receive small payments in return for routing retail investors' orders to market makers. Market makers often execute the orders themselves as well, whereby the firms can arbitrage the price they are selling and buying securities in a process called internalization. At the crux of the debate that has raged for some time is the conflict of interest that even Gensler noted is inherent in such a setup.
"The brokers' motivation to generate dealer profits seems to overcome the brokers' fiduciary responsibility to obtain the best execution price for the customer, raising ethical questions," a 2008 paper co-authored by Notre Dame professors of finance Robert Battalio and Tim Loughran reads. "Purchasers and internalizers of order flow in the market may cause prices quoted on the NYSE to deteriorate, making all investors worse off."
In that sense, some of the benefit of zero-commission trading and the "democratization of markets" hailed as a win for retail investors was largely a ruse.
The SEC's Gensler termed this practice between broker-dealers and market makers a cause of a less-than-efficient market outcome in his interview with Barron's. Given the SEC's mission statement explicitly states the commission's responsibility to maintain "fair, orderly, and efficient markets," this is not a statement to simply brush off.
Breaking the Business Model
Of course, if retail investors were not the big winners from low-cost trades, the gaze of more skeptical onlookers and indeed regulators quickly moves to the parties causing the conflict of interest. While market makers are unlikely to be significantly impacted, popular zero-commission brokerages such as Robinhood could quickly find themselves victims of their own success.
In fact, some enforcement of order execution issues have already affected Robinhood through hefty fines.
In May 2019, the SEC opened an investigation into Robinhood's PFOF practices, eventually settling with Robinhood in December 2020. In the agreement, Robinhood was required to pay a $65 million civil penalty. While not a significant penalty as compared to its revenue figures, the penalty was perhaps just a warning shot of bigger punitive measures to come if not a full ban on a key income-generating practice.
However, despite the warning from the SEC implied by the penalty, Robinhood has not slowed down its pursuit of the practice. The firm's percentage of revenue generated by PFOF grew from 75% at the time of the settlement to over 80% by the first quarter of 2021.
This absolutely integral role for PFOF far outpaces peers such as Schwab and the Morgan Stanley (MS) owned E*Trade. And the firm has little flexibility to change its business model to the same degree as these peers, making the business essentially "uninvestable," according to Wolfe Research analyst Steven Chubak.
"HOOD bulls may argue that PFOF has periodically been in the spotlight many times over the past decade and every time it ultimately amounts to nothing," he admitted in a note to clients. "However, this feels a bit different, for a few reasons."
Chubak noted that Gensler appears highly knowledgeable on the subject, setting him apart from political opportunists before him. Also, he is shifting tone quickly toward a negative tenor, and has also called for in-depth reviews of best execution requirements. Chubak added that FINRA's wariness about PFOF only increases the likelihood that sweeping action will finally come to fruition.
"Without improved visibility on where the regulatory puck is heading on PFOF there is no way for investors to handicap the risk of tougher regulation eliminating a substantial portion of HOOD's revenue," Chubak wrote. "Sure, PFOF noise has been around for years and nothing's ever been done yet. But 'yet' is the key word here."
If it were to happen, it would essentially break the Robinhood business model fundamentally.
To be sure, a crackdown on PFOF need not be an all-or-nothing move by the SEC as an outright ban is merely "on the table." At the very least, it's time to assess things before any sweeping changes are enacted. Additionally, it is highly like that firms will be able to buy time with legal challenges to new regulatory measures should they be implemented.
"Substantial due diligence needs to be performed by the industry ahead of any such change," Dan Raju, CEO of retail trading platform Tradier, told Real Money, adding that he sees a total ban as unlikely in the immediate future. "[But] retail investors will benefit [from such a change] because it creates greater transparency and simplicity in their trading."
Downside for Diamond Hands?
The retail investing angle could also prove to be a double-edged sword, especially for the much-debated meme stocks that dominate trading discussions on zero-commission platforms.
According to market analytics firm Alphacution, options on meme stocks like GameStop (GME) , AMC Entertainment (AMC) , BlackBerry (BB) , and Bed Bath & Beyond (BBBY) made up 61% of total PFOF in the calendar year 2020. The figure indicates the key role market makers played in the meme stock surges, as well as just how much they knew early about the significant options action. With trading firms collecting this information on the burgeoning momentum, it would seem unlikely the big money simply sat on the sideline.
Still, the speculative frenzy that feeds the rapid rise in these names is at least sparked by retail investors on these platforms. If their trading appetite falters in the face of fees, many meme-stock candidates could see their stock prices quickly curtailed.
"My belief is that eliminating payment for order flow would discourage retail speculation and that would be a positive for the markets," Bob Johnson, Professor of Finance at the Heider College of Business told Real Money. "If the SEC ends payment for order flow, it really wouldn't affect the all-in costs of retail speculators in meme stocks, but since these special investors don't understand their all-in costs, it may lead to less speculation in meme stocks...that would be a good thing."
Victor Hogrefe, CEO of high-frequency trading firm EonLabs, was less pessimistic on this point, expressing his confidence in the staying power of the diamond-handed online forum dwellers and their ability to drive both share prices and attract eyeballs to the action.
"I don't think the meme stocks are going to go anywhere. The Internet is always getting better at creating these kinds of situations," he told Real Money. "In fact, that seems to be a kind of rule: on the Internet, the most entertaining outcome will always overtake a boring alternative outcome."
