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

This article first appeared in Morning Brief. Get Morning His Briefs sent straight to your inbox every Monday-Friday by 6:30am ET. apply

September 23, 2022

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

Anyone else sick of talking about the Federal Reserve? Of course, the Federal Reserve and its fight against inflation using higher interest rates is very important. But we need a break.

Now let’s move on to another important question. Are zero-fee brokerages fooling you?

The U.S. Securities and Exchange Commission seems to have decided otherwise. Bloomberg reports that the agency has decided not to ban payments on his order flow, known as PFOF. This is the practice of brokers processing customer transactions through wholesalers, a practice critics say imposes hidden fees on individual traders.

The argument against PFOF is that, in theory, brokerage firms should aim to make profits for their clients, not market makers like Citadel Securities, so the practice is a contradiction. In fact, it’s hard to find many people in favor of a blanket ban on PFOF other than meme stock enthusiasts on 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.

“The SEC will not enter into disputes with order flow or other certain anti-investors if the best execution is required to be the best price available at the time, given the order characteristics and market conditions. We don’t need to ban payments for full market practices,” said head Dennis Kelleher. The CEO of investor advocacy group Better Markets told Yahoo Finance in an email: “That way the SEC will whack-a-mole with an industry that is relentless in creating new wealth extraction practices that sidestep the rules of the past. You won’t have to do that,” he said. We need new rules tomorrow. ”

An important revenue stream for commission-free brokers

In the PFOF model, commission-free brokerage firms such as Robinhood and Schwab process investors’ stock purchase orders and pass them on to wholesalers such as Citadel Securities and Virtu Americas. These market makers then execute trades and pay brokerage firms to route the trades through them.

If the market maker can buy the stock at a lower price than the customer requested, the brokerage firm and the market maker split the savings. The money that intermediaries put in their pockets, or “order flow payments,” can fund their commission-free business.

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

This is an important source of income for Robinhood, and it popularized the practice in 2020 when US households were ready to enter the market following stimulus checks. Since then, trading at Robinhood has declined (along with the stock price) and we have tried to diversify our revenue streams.

PFOF accounted for 9% of Robinhood’s equity revenue, 36% of options revenue and 18% of crypto revenue last quarter, according to JMP Securities analyst Devin Ryan. The company’s stock soared following reports that the SEC had no plans to introduce a ban. But then Robinhood erased that gain, dropping 2.72% to $9.65 a share for him.

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

As expected, trading companies see no problem with the current system, claiming retailers are already getting good prices. SEC Chairman Gary Gensler largely took the opposite position, saying in June that payments for flow of orders “could distort routing decisions.”

But experts argue that eliminating PFOF is attacking the wrong problem. The problem, according to recent research by several business school professors, is that the price a retail investor can pay varies greatly depending on which market maker routes the order. According to that study, differences in brokerage platforms and where orders are routed can cost small investors up to $34 billion annually in losses.

Watch: How does payment for order flow work?

The solution to this problem is not to get rid of PFOFs, said study co-author Christopher Schwartz, a professor at the University of California, Irvine. Instead, brokerages should be more transparent about prices, he said.

The debate over the PFOF ban is “the bright spot in the room where everyone is distracted from the issue of market centers giving different brokers very different executions. And that execution has nothing to do with PFOFs.” ‘, Schwarz wrote to Yahoo Finance on Thursday.

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

“The US has the most liquid capital markets in the world, but that may not be the case once regulators get involved,” he wrote. “As long as competition continues, things will get better and transaction costs will drop even further.”

No doubt many on Wall Street agree with Dillian, and papers like Schwartz’s may have moved the SEC to look at the issue differently. Of course, authorities may end up banning or limiting her PFOF. In the meantime, it’s hard to tell if investors are mad at his PFOF or just wary of the market these days.

The number of people transacting through Robinhood has fallen from 17.3 million in December last year to 14 million by June 2022. As Robinhood’s user base dwindled, alternatives emerged, such as Public.com, which does not offer commission-free order flow payments, but instead allows users to provide tips to brokers executing trades. According to the company, the number of users has increased from 1 million in mid-2021 to 3 million in early 2022.

Ultimately, PFOF may fall out of favor regardless of whether the SEC steps in and cracks down on the practice.

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