By: Evan Dubow, November 15, 2021
“Payment for Order Flow” is the practice of brokerage firms profiting from the routing of customer trades through certain market makers that incentivize the usage of its market by providing monetary commissions to the broker. Online brokerages, such as Robinhood, utilize Payment for Order Flow as its primary means for revenue and profit. However, more and more regulatory agencies across the world are beginning to question its ethical permissibility.
Retail trading involves several steps. A retail investor places a trade at a publicized price on an application or website. After the trade is placed, the brokerage firm routes the trade through a market maker, which matches the buyer with a seller of the security. Given market fluctuation, the price may vary a few cents. Finally, a clearinghouse clears the transaction when it confirms both sides of the transaction have given consideration.
By utilizing Payment for Order Flow, investors may not be getting the best price available on the market. Contrary to the “Duty of Best Execution,” which requires firms to provide customers the best price on the market when a trade is executed, Payment for Order Flow directly pits the interests of an investor with those of the brokerage. Where a broker profits from the routing of trades while simultaneously owing its customers a duty of best execution, the decision of which market maker to route order flow begs an inquiry into how a broker could, at all times, maintain its required duty to investors and quench its own financial interests.
This conflict may have minimal visible effects on investors; however, the decision has huge profit bearing implications for brokerage firms. When routing hundreds of millions of dollars in trade volume, a small payment for order flow incentive turns into a large profit, very quickly.
In 2012, the United Kingdom’s regulatory agency controlling brokerages and investment institutions realized the inherent issues associated with Payment for Order Flow practices. Impossible to eliminate the conflict of interest, the Financial Services Authority (now called the Financial Conduct Authority “FCA”) banned the practice of Payment for Order Flow altogether. This action taken by the FCA boosted the percentage of customer transactions receiving the best price on the market from 65% in 2010 to 90%, just two years after the ban, in 2014.
Some Payment for Order Flow proponents argue that retail investors suffer from the ban. Arguments to this end include that commission-free trading will not be possible due to higher execution costs and less income for brokerages. However, brokerage firms are finding other sources of income such as selling user data through cookies and advertising.
In the wake of the United Kingdom’s ban on Payment for Order Flow, domestic regulators, such as Chairman of the SEC, Gary Gensler, have grown more skeptical of the practice. Gensler states that banning Payment for Order Flow is “on the table.” On top of conflict issues, legislators in the House of Representatives and Senate are concerned with the lack of transparency involved with hidden fees that transcend to investors without them ever knowing.
Furthermore, Payment for Order Flow practices give brokerages an “inside edge” by knowing which direction retail investors are trading. Brokerage firms can then sell this information to more sophisticated traders such as fund managers and ultra-wealthy investors, that have the financial means to do so, for its own profit. Permitting sales as such may drive prices in the opposite direction sought by retail investors thereby compounding the inherent conflict issue originally addressed. Consequently, Robinhood settled with the SEC for a $65 million fine for failing to provide adequate disclosures to its customers regarding its Payment for Order Flow practices.
In conclusion, Payment for Order Flow practices are under scrutiny in the United States – domestic brokerage firms have been fined for illegitimate trade practices associated with Payment for Order Flow, foreign regulators have banned Payment for Order Flow, and domestic regulators outwardly express distaste toward the practice. Thus, United States investors and investment firms can likely expect domestic restrictions or limitations placed on Payment for Order Flow practices.