This Will Be the SEC’S Next Target

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On Tuesday, Gary Gensler appeared before the Senate Banking Committee to take questions about the future of the U.S. financial system.

Who is Gary Gensler?

A graduate of the Wharton School of the University of Pennsylvania, Gensler became one of the youngest people ever to reach the level of partner at Goldman Sachs, at 30 years old. He would later enter public service with the Clinton administration.

He worked at the Treasury Department, helped shape the Sarbanes-Oxley Act of 2002 on Wall Street accounting standards, reformed the global derivatives market while at the Commodity Futures Trading Commission, and later headed Maryland’s Financial Consumer Protection Commission.

He’s a pure reformer and Wall Street cop of the highest degree.

Fast forward to 2021, and Gensler is now the head of the U.S. Securities and Exchange Commission (SEC). Gensler maintains oversight of the U.S. financial markets and could bring some of the most significant changes to trading rules in decades.

Today, most speculators are primarily interested in the SEC’s role in regulating the Wild West of cryptocurrency markets. Or, critics of today’s markets want to restrict high-speed trading and other functions that give Wall Street an advantage over retail investors.

But these are not the stories I watched on Tuesday. I wanted to know how Gensler’s views of a controversial trading mechanism could alter the future of Robinhood, the digital online broker that has disrupted the discount brokerage industry in recent years.

Let me explain what this mechanism is and why it matters to your money.

What is Payment for Order Flow?

You’ve probably heard some chatter around a process called payment for order flow.

As I noted yesterday, GameStop experienced a massive short squeeze earlier this year that sent shares to record highs. At the center of this huge pop were traders using the Robinhood application. After the short squeeze forced Robinhood to put trading limits on certain securities, public interest exploded in Robinhood’s practice that gives people access to commission-free trading.

You see, Robinhood’s business model operates around payment for order flow.

Payment for order flow, which represents 81% of Robinhood’s revenue, is a controversial practice where the broker sells its customers’ market orders to third parties, who pick which trades they want to execute and earn fees in the process. Robinhood receives a payment for routing its trades to these parties. One of these parties is Citadel Securities, a company that generated so much volume from Robinhood and others that it nearly matched the volume of the Nasdaq in December 2020.

When Robinhood routes orders to these third parties, it receives money (maybe fractions of a penny per share) for doing so.

In the old days of traditional brokerages, the broker would execute the trade on the client’s behalf and charge a commission. (Remember paying $6.95 per trade?) But payment for order flow changed the landscape. Once Robinhood started introducing commission-free trading (since they were getting paid by someone else), the entire online discount brokerage industry eliminated these fees.

But why is this controversial? Three reasons.

The first is tied to the price of the stock when Robinhood processes an order. You see, when Robinhood processes these trades through third parties, it is really routing them to market makers instead of to a stock exchange. When this happens, the third party is able to exploit the bid-ask spread on the open market.

They can sell shares at the higher ask price and then buy them at the lower bid price. If you’re processing millions of shares per day, you can make quite a bit of money on the spreads between the bid and ask.

The second controversy: The market maker can exploit the information in the form of order flow they purchase from Robinhood. When traders on Robinhood are piling into a stock, the market makers can see the trend before the rest of the market.

So, if millions of people are buying up a stock, market makers can exploit this information for their own gain, at least in theory. There remain a lot of questions about whether companies are front-running trades or even shorting stocks when the speculation starts to hit nosebleed levels.

The third challenge is whether investors really get the benefit promised. When Robinhood says that investors can get “price improvement” by routing these trades through third parties, it doesn’t mean that they are getting the best price possible.

Remember, the third party is allegedly exploiting the spreads, so buying at the best price possible might be in your interest, but it’s certainly not in theirs.

Are There Benefits?

There are some people who believe that payment for order flow is a vile and treacherous practice that enriches Wall Street and preys on the pocketbooks of retail investors. They argue that if the trades are free… then YOU are the product.

And that’s a tough argument to beat in an era when other companies like Facebook, Amazon, and more make so much money off consumer data.

But this argument isn’t absolute.

People also rightly point out that payment for order flow was a process pioneered by Bernie Madoff. I don’t need to spend too much time talking about him after he bilked thousands of investors of nearly $65 billion in a massive Ponzi scheme.

But there are others, however, who argue it’s just a cost of doing business and a significant opportunity for retail investors. After all, interest in the market has exploded over the past year. With more participants in the market, the argument goes, less friction exists and greater liquidity abounds. This argument suggests that without payment for order flow, retail investors could face larger spreads in the bid-ask price, less liquidity, and fewer benefits in execution.

And — of course — there’s the price. Without payment for order flow, brokers would still likely route orders to market makers to achieve better execution for retail trades. However, without brokers like Robinhood securing a source of revenue from order flow, fees would likely increase. Ironically, the market makers could end up making even more money in the process.

Who Wins or Loses?

Ahead of this week’s testimony, Barron’s conducted an interview with Gensler, who said that banning payment for order flow is “on the table.”

Should the SEC ban the practice of payment for order flow, it would hurt Robinhood’s entire business model. As I noted, the practice composes about 81% of the company’s revenue.

That is the largest revenue stake of any company in the financial business by far.

Right now, Robinhood (HOOD) is trading at roughly $40 per share and rates as bearish based on consumer sentiment indicators from our partners at LikeFolio. Shares have pulled back from their early August high of more than $70 per share. We’ll continue to monitor this situation, and add the stock to our watch list. If the SEC balks on a ban, shares could run. But if the SEC cracks down, things could get very rocky for the future of the brokerage.

What is your opinion on payment for order flow? I’d love to hear your thoughts. You can send your thoughts or any other feedback here, via my dedicated TradeSmith Daily inbox. I can’t respond personally to every email, but I read them all.

I’ll be back tomorrow to talk about another controversial practice that is also attracting the SEC’s attention.