RIP, PFOF?

Free stock trading is nothing new by now. Pioneered by upstart digital-only brokers like Robinhood Markets, stalwarts like Fidelity, Charles Schwab, and E-Trade have offered zero-commission trading in stocks, ETFs, and other securities for more than a year.

That leaves them to generate sales by other means. Schwab is a full-fledged bank, offering checking and savings accounts, loans, and a credit card. E-Trade is by now a subsidiary of Morgan Stanley, which acquired the broker last year to funnel customers to its wealth management business. And Fidelity is a giant in the world of mutual funds, exchange-traded funds, and asset management. They all operate brokerages, but make money off those customers in other areas.

Robinhood, on the other hand, has few products other than its trading app. It relies most heavily on a practice called "payment for order flow," in which its customers' buy and sell orders are routed to market makers to execute. Those firms profit from minuscule differences in the bid and offer prices for stocks, options, and cryptocurrencies, and split those gains with Robinhood.

"For most brokers, the practice is a relatively small part of their business model—often less than 10% of revenue," wrote Barron's Avi Salzman today. "But for Robinhood, which pioneered zero-commission trading, payment for order flow makes up about 80% of its revenue."

Robinhood warned investors in its initial public offering prospectus earlier this summer that any change to its ability to charge payment for order flow is a risk factor. Well, the chairman of the Securities and Exchange Commission told Avi today that banning the practice altogether is “on the table.”

Charles Schwab and Morgan Stanley stocks fell 3.2% and 1.3%, respectively, today. Virtu Financial, a market maker, lost 3.8%. Robinhood shares, meanwhile, tumbled almost 7%.

Avi wrote:

[SEC Chairman Gary] Gensler says the practice has 'an inherent conflict of interest.' Market makers make a small spread on each trade, but that’s not all they get, he said.

'They get the data, they get the first look, they get to match off buyers and sellers out of that order flow,' he said. 'That may not be the most efficient markets for the 2020s.'

He didn’t say whether the agency has found instances where the conflicts of interests resulted in harm to investors. SEC staff is reviewing the practice and could come out with proposals in the coming months.

Gensler has mentioned several times that the U.K., Australia, and Canada forbid payment for order flow. Asked if he raises those examples because a ban could also happen in the U.S., he replied: 'I’m raising this because it’s on the table. This is very clear.'

The focus on payment for order flow, Avi writes, is part of a push by Gensler to improve the transparency and efficiency of markets. That includes taking a closer look at trading in dark pools, in which trades never make it to public exchanges. 

For more on Gensler's and the SEC's latest thinking, read the rest of Avi's report here.