Are brokerages for commission ripping you off? The SEC doesn’t think so: Morning Brief

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September 23, 2022

Today’s newsletter by Julie Heyman, anchor and reporter at Yahoo Finance. Follow Julie on Twitter Tweet embed.

Who is tired of talking about the Federal Reserve? Of course, the Fed and its fight against inflation using higher interest rates are of vital importance. But I need a break.

So, let’s move on to another important question: Are commission-free brokerages ripping you off?

Obviously, the SEC decides it isn’t – or at least the SEC wouldn’t do anything about it even if it were. Bloomberg reported that the agency decided not to block payment for order flow, known as PFOF. This is a practice in which brokerages process clients’ deals through wholesalers, in a way that critics say burdens individual traders with hidden fees.

The argument against PFOF is that this practice presents a conflict because, in theory, brokerages should aim to make money for their clients – not market makers like Citadel Securities. In fact, it’s hard to find many in favor of a blanket ban on PFOF apart from the adorable stock buffs who circulate on Twitter and Reddit. Instead of banning PFOF, it would be wise to focus on price transparency and require brokers to execute trades at the best possible price at that time.

Dennis Keeler, president of investor advocacy group Better Markets, told Yahoo Finance in an email. “If it did, the SEC would not have to play whack-a-mole with an industry that is relentless in creating new wealth-extracting practices that eschew yesterday’s rules and require new ones tomorrow.”

An important source of income for commission-free brokerages

In the PFOF model, a commission-free brokerage such as Robinhood or Schwab processes an investor’s request to purchase shares and passes it on to a wholesaler, such as Citadel Securities or Virtu Americas. These market makers then execute the transactions and pay the brokerage firms to route the trade through them.

When the market maker can buy a stock at a price lower than what the customer asks for, the broker and the market maker split the savings. The money that brokerages get, “pay for order flow,” can fund their business without commission.

Robinhood Markets, Inc. CEO and co-founder Vlad Tenev arrives on Wall Street after the company’s initial public offering in New York City, US, July 29, 2021. REUTERS/Andrew Kelly

This is a significant source of revenue for Robinhood, who popularized the practice in 2020 when US households were awash with stimulus checks and ready to play in the market. Since then, Robinhood’s trading has plummeted – along with its share price – and it has tried to diversify its revenue streams.

According to analyst Devin Ryan of JMP Securities, PFOF accounted for 9% of Robinhood’s stock revenue last quarter, 36% of options revenue, and 18% of crypto revenue. The company’s shares jumped on reports that the Securities and Exchange Commission was not planning to impose a ban. However, Robinhood then erased those gains and closed down 2.72% at $9.65 a share – well below this time last year, when it traded five times as much.

However, Bloomberg’s report on the SEC’s decision on PFOF is clearly helpful to Robinhood. Does this gain come at the expense of small investors?

Trading companies believe, as expected, that there is no problem with the current system, and argue that retailers are already getting good prices. SEC President Gary Gensler has largely taken the other side, saying in June that pushing for order flows “can distort routing decisions.”

However, experts argue that eliminating PFOF would attack the wrong issue. The problem, according to a recent study by several business school professors, lies in the very different prices that retail investors can pay depending on the market maker’s path to their orders. This study found that differences between brokerage platforms and where the demand is directed can cost small investors up to $34 billion annually.

Watch: How does Pay to Order Flow work?

The solution to this problem is not getting rid of PFOF, according to Christopher Schwartz, a professor at the University of California Irvine, who co-authored the study. Instead, he said, brokerages should be more transparent about pricing.

The controversy over banning PFOF “is the shiny thing in the room that distracts everyone from the question of market centers offering very different execution to different brokers. And that implementation has nothing to do with PFOF,” Schwartz wrote to Yahoo Finance on Thursday.

Jared Delian, editor and publisher of the Daily Dirtnap and investment strategist at Mauldin Economics, argued last month for Bloomberg Opinion that PFOF regulation might backfire.

“The United States has the deepest and most liquid capital markets in the world, but we may not do that if regulators start getting too involved,” he wrote. “As long as there is competition, things will get better and trading costs will fall even more.”

Undoubtedly, many on Wall Street agree with Dillian, and newspapers like the one from Schwartz may have influenced the Securities and Exchange Commission to look at the issue differently. Of course, the agency may end up banning or restricting the PFOF. In the meantime, it’s hard to tell if investors are angry at PFOF or just worried about the market these days.

The number of people trading through Robinhood has fallen this year, to 14 million users transacting per month by June 2022 from 17.3 million last December. With Robinhood’s user base shrinking, alternatives have emerged – including, which is commission-free, doesn’t offer payment for order flow, and instead allows users to advise brokers executing their trades. The company says the number of its users has grown from 1 million in mid-2021 to 3 million in early 2022.

Ultimately, PFOF may not get attention, regardless of whether the Securities and Exchange Commission stepped in to monitor the practice.

What are you watching today

Economic calendar

  • 9:45 a.m. ET: Standard & Poor’s global manufacturing in the United StatesPre-September (expect 51.1, 51.5 over previous month)

  • 9:45 a.m. ET: S&P Global US Services PMI1st September (expect 45.0, 43.7 over the previous month)

  • 9:45 a.m. ET: Standard & Poor’s global manufacturing in the United StatesSeptember 1st (46.0 expected, 44.6 over the previous month)


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