The US Securities and Exchange Commission is mulling a ban on Payment for Order Flow, but what will this mean for Robinhood’s stock?
A proposal to ban the practice of Payment for Order Flow (PFOF) has been floated by the Securities and Exchange Commission (SEC), a direct threat to one of Robinhood’s key revenue drivers and by extension, Robinhood’s stock [HOOD]. Chairman Gary Gensler said in an interview with Barron’s at the end of August that a full ban was “on the table” and that proposals could be made public in the coming months.
Reuters reported, Gensler has for some time been critical of PFOF – whereby broker-dealers, like Robinhood, are paid by wholesale market-makers to send them client orders, which they then execute on their own trading platform or a third party’s. As a result, any attempt to ban the practice in the US is understandably feared by investors in Robinhood’s stock.
Gensler believes PFOF, which has been banned in the UK, Canada and Australia, can create conflict-of-interest questions, such as encouraging brokers to send orders to the market-makers paying the highest fees, rather than those who will get end customers the best deal. This is known as ‘best execution’.
“Are customers getting best execution in the context of that conflict? Are broker-dealers incentivised to encourage customers to trade more frequently than is in those customers’ best interest?" Gensler asked during a speech at a conference of investment bank Piper Sandler in June.
Robinhood stock falters
According to Bloomberg, online trading app Robinhood is squarely in the firing range in case of a ban as it gets around 80% of its revenues from PFOF, through selling its investors’ orders to market-makers such as Citadel Securities.
Robinhood was heavily criticised earlier this year for putting trading limits on its clients investing in GameStop [GME] during a Reddit-fuelled trading frenzy. Some said this caused, rather than prevented, volatile market swings and may have protected the hedge funds that had shorted the GameStop stock.
Robinhood’s stock has been blasted by the recent uncertainty around PFOF. Its stock has dropped from $49.38 at the close on 24 August to $43.35 at the close on 3 September, US markets were shut for a public holiday on Monday.
If the PFOF ban is imposed, then Robinhood would presumably have to change its business model and start charging commission, which could impact on retail investor demand.
Robinhood has reacted strongly, telling Reuters that “the company would defend its customers and ensure it does not put up barriers that keep people out.” It could even take the SEC to court if the ban is imposed.
Market-makers have also defended the practice, stating that it reduces costs and improves liquidity for investors.
"The idea of banning payment for order flow is pretty draconian,” Robinhood’s chief legal officer Dan Gallagher told Barron's. “This is the revenue that provided us the ability to offer commission-free trading with no minimum balance. There would be a long line of folks that would sue.”
Other online brokers also took a hit. Charles Schwab’s [SCHW] stock has fallen from $75.84 at the close on 27 August to $72.09 at the close on 3 September. Electronic trading firm Virtu Financial [VIRT], which handles orders from retail brokers, saw its stock drop from $26.03 at the close on 27 August to $24.46 at the close on 3 September.
Wolfe Research analyst Steven Chubak says Robinhood would be left “uninvestable” if a ban was imposed: "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. However, this feels a bit different.”
Matt Levine, writing in Bloomberg, says that if a ban is imposed, it does not automatically mean that brokers such as Robinhood would have to introduce commission and risk putting off a new cadre of retail investors. They could just develop market-making services.
“If Robinhood can’t subcontract this internalising function to a market-maker, then it can just do it in house,” he said. “It can use its balance sheet to internalise customer trades, executing those trades at better prices than are available on the public exchange and collecting a spread for itself.”
Cathie Wood, founder of Ark Invest, which holds the Robinhood stock, is less perturbed. “We actually think that not much is going to change because the system has been so good from an execution point of view for the end investor,” she told Yahoo Finance. "Robinhood has done a great service to the investing community.”
In addition to PFOF, the SEC also has concerns that fintech brokers are incentivising the gamification of trading. Gensler said that the SEC will step up its inquiry into whether financial technology and its behavioural prompts can mislead investors over the profits they can make, encouraging them to trade more.
“While new technologies can bring us greater access and product choice, they also raise questions as to whether we as investors are appropriately protected when we trade and get financial advice,” Gensler said in an SEC release.
The SEC’s true aim, however, appears to go beyond Robinhood and fintech. It seems the intent is to change the market practice of internalising trade and routing them instead through public stock exchanges, reports Bloomberg.
“Also, on the table is how do we move more of this market to transparency,” Gensler said in that Barron’s interview. “Transparency benefits competition, and efficiency of markets. Transparency benefits investors.”
We will have to wait for more transparency on its PFOF stance to see what happens next.