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

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September 23, 2022

Today’s newsletter is from Julie Hyman, anchor and correspondent at Yahoo Finance. Follow Julie on Twitter @juleshyman.

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

So, on to another crucial question: are no-commission brokers ripping you off?

The Securities and Exchange Commission apparently decides not — or at least the SEC isn’t going to do anything about it, even if they are. Bloomberg reports that the agency has decided not to ban payment for the order flow, known as PFOF. That’s a practice where brokers process customers’ transactions through wholesalers, in a way that critics say saddles individual traders with hidden fees.

The argument against PFOF is that the practice creates a conflict, because in theory brokers should aim to make money for their clients – not market makers like Citadel Securities. In reality, it’s hard to find many who are in favor of a blanket ban on PFOF, aside from meme-stock aficionados who populate Twitter and Reddit. Rather than ban PFOF, the SEC would be wise to focus on price transparency and require brokers to execute trades at the best possible price at the time.

Read:Ray Dalio says stocks, bonds have further to fall, sees U.S. recession in 2023

“The SEC need not prohibit payment for order flow or other specific anti-investor, conflict-ridden market practices if it requires best execution to be the best price available at the time order characteristics and market conditions are given,” Dennis Kelleher, head of the advocacy group Better Markets, Yahoo Finance told Yahoo Finance in an email: “If it does, the SEC won’t be kidding an industry that is relentless in creating new wealth-winning practices that violate yesterday’s rules and regulations.” need new rules tomorrow.”

A critical income stream for commission-free brokers

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

When the market maker can buy a stock at a lower price than the customer has asked for, the brokerage and market maker split the savings. The commission-free business can be financed with the money that the brokers put into the pocket, the ‘payment for the order flow’.

Read:Spac booster Chamath Palihapitiya throws in the towel

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

This is a key revenue stream for Robinhood, which popularized the practice in 2020 when US households were done with stimulus and ready to play in the market. Since then, trading on Robinhood has declined — along with the stock price — and has sought to diversify its income streams.

According to JMP Securities analyst Devin Ryan, PFOF made up 9% of Robinhood’s equity income, 36% of option income and 18% of crypto income in the quarter. Shares of the company skyrocketed after reports that the SEC had no intention of imposing a ban. However, then Robinhood wiped out those gains and closed 2.72% at $9.65 a share — much less than around this time last year, when it was trading five times that.

Still, it’s clear that the Bloomberg report on the SEC’s decision regarding PFOF is good for Robinhood. Is that profit at the expense of small investors?

Read:Fed feeds recession fears, Japan jumps in to support yen

Trading firms, predictably, think there is no problem with the current system and claim that retailers are already getting good prices. SEC chairman Gary Gensler has largely sided with the other side, saying in June that payment for the order flow “could disrupt routing decisions.”

However, experts argue that eliminating PFOF would address the wrong problem. The problem, according to a recent study by several business school professors, is the vastly different prices retail investors can pay depending on the market maker who forwards their orders. That study found that differences between brokerage platforms and where an order is routed can cost retail investors up to $34 billion a year.

Watch: How does the order flow payment work?

The solution to that problem is not to get rid of PFOF, according to Christopher Schwarz, a professor at the University of California Irvine who co-authored that study. Instead, he said, brokers should be more transparent about prices.

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

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

“The US has the deepest, most liquid capital markets in the world, but maybe not if regulators get too involved,” he wrote. “As long as there is competition, things will get better and trading costs will fall even further.”

No doubt many on Wall Street agree with Dillian, and newspapers like Schwarz’s may have led the SEC to look at the matter differently. Of course, the agency may eventually ban or restrict PFOF. In the meantime, it’s hard to tell whether investors today are mad at PFOF or just wary of the market.

The number of people trading through Robinhood dropped this year to 14 million monthly user transactions in June 2022, from 17.3 million in December last year. As Robinhood’s user base has dwindled, alternatives have popped up — including, which is commission-free, offers no payment for the order flow, and instead gives users a tip to brokers who execute their trades. The company says the number of users grew from 1 million in mid-2021 to 3 million in early 2022.

Ultimately, PFOF may fall out of favor whether or not the SEC steps in to monitor the practice.

What to watch today

Economic calendar

  • 9:45 a.m. ET: S&P Global US Manufacturing PMISeptember Preliminary (51.1 expected, 51.5 during the previous month)

  • 9:45 a.m. ET: S&P Global US Services PMISeptember Preliminary (45.0 expected, 43.7 during previous month)

  • 9:45 a.m. ET: S&P Global US Manufacturing PMISeptember Preliminary (46.0 expected, 44.6 during previous month)


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