Exploring the SEC’s bid to Ban Payment for Order Flow: What Could Replace PFOF?
Recently, the SEC chairman, Gary Gensler sent shockwaves through the world of retail investing by stating that a full ban on the popular ‘payment for order flow’ (PFOF) operating model that enables online brokerages to offer ‘zero-commission’ trading is “on the table.” But what would a world without PFOF look like? And what could the controversial practice be replaced by?
It’s fair to say that PFOF has played a central role in the recent boom in retail investment that we’ve seen over the past two years. Combined with the stimulus packages that investors had at their disposal in the wake of the Covid-19 pandemic, online brokerages experienced unprecedented growth in users that heavily impacted Wall Street with the emergence of meme-based investments and short squeezes.
As Nasdaq data shows, the widespread switch from brokerages to go to zero-commission, payment for order flow, models sparked a period of exponential growth across the industry - to the benefit of the brokerages welcoming this new wave of investment.
However, the US Securities and Exchange Commission has now threatened that the days of PFOF may be numbered. With the model acting as a key part of the success of platforms like Robinhood and E*Trade, could we see a fundamental shift in the retail investing landscape? Or are the SEC’s threats nothing but hot air?
How Does Payment For Order Flow Work?
Firstly, let’s look at why PFOF is regarded as a controversial way for brokerages to make money.
According to Northern Trust, brokerage firms partaking in payment for order flow receive money from third parties in exchange for directing their clients’ orders to the trading desks of specific market makers. This helps to ensure that the selected market makers get the lion’s share of business regardless of their pricing structures.
The revenue generated from the payments brokerage firms receive for guaranteeing this order flow has allowed online brokers to run commission-free models to attract more custom.
This implies that market makers may be capable of dropping a competitive pricing structure due to their guaranteed order flow, leaving retail investors to lose out on the price of the assets they buy despite avoiding having to pay commissions.
Although this approach has been regarded as controversial among some Wall Street stalwarts like Warren Buffett, it’s worth noting that PFOF is nothing new, and the SEC’s Rule 606 has long stipulated that the disclosure of such arrangements to customers is all that’s currently required to operate the model.
‘An Inherent Conflict of Interest’
SEC chairman Gensler labelled payment for order flow “an inherent conflict of interest” for brokerage firms that are intent on providing a high quality of service for their customers whilst also looking to expand their revenues where possible.
The Securities and Exchange Commission clearly fears that brokerages are more inclined to accept larger market maker handouts at the cost of competitive pricing for its users.
But what would happen to the retail investing landscape should PFOF disappear? And could the industry continue to thrive in lieu of the lucrative business model?
A Future Built on Tip-Based Investing?
We may already have an insight into a future without PFOF brokerages in the form of Public.com, which took the bold step of remaining commission-free whilst also abandoning the controversial payment for order flow model.
In February 2021, Public.com announced in a blog post that the company “will stop participating in the practice of PFOF (payment for order flow) and instead introduce a tipping feature on trades. Trades will remain commission-free and tipping is entirely optional."
Although the act of relying on the generosity of its users may seem like a significantly risky strategy, Public.com achieved unicorn status just weeks later as the company closed a $220 million funding round to a valuation of $1.2 billion.
With the prospect of reverting back to commission-based revenue likely to be a difficult approach for brokerages enticing investors who have been used to PFOF and ‘zero-commission’ trading for the past two years, tip-based investing may become more common as arguments surrounding payment for order flow rage on. The emergence of fintechs supporting micro-payments may help brokerages to set up systems where users can set themselves up to pay minuscule amounts of money when selling successful stocks.
PFOF Going Nowhere
Although Public.com has made the transition towards a tip-based operating model, there’s widespread scepticism about SEC carrying out its threat of banning payment for order flow.
The U.S. Securities and Exchange Commission is “going to arrive at the conclusion that payment for order flow is undoubtedly an amazingly good thing for retail investors and they’re not going to ban it,” dismissed Dan Gallagher, Robinhood’s chief legal advisor, who himself was the agency’s commissioner between 2011 and 2015.
Furthermore, Maxim Manturov, head of investment research for Freedom Finance Europe, believes that a lack of credible alternatives means that a prospective ban on PFOF would be too damaging for the SEC to carry out.
“It is more likely that the SEC will revise the rules regarding PFOF rather than ban the procedure altogether, as many believe that the SEC will be reluctant to take any action that might increase costs for retail investors, especially when PFOF has opened investments to millions of young people. Furthermore, no credible evidence has been presented to support a better alternative,” Manturov explained.
In his opinion column for Bloomberg, Nir Kaissar argued that “payment for order flow is an indispensable tool in the democratization of markets. Coupled with the ability to buy and sell fractional shares of companies, the practice has made stock investing available to everyone. But it’s under assault, undeservedly so, and needs support.”
With the opposition to PFOF clear in their conviction, it seems unlikely that we’ll be seeing the popular operating model find itself on the wrong side of an SEC ban any time soon. But with the lack of transparency that the approach can bring, we may well see the SEC demand that brokerages deliver more clarity to customers about where the money for their stocks and shares is really going. After all, the true democratization of finance will be built on trust and transparency.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.