The U.S. Securities and Exchange Commission (SEC) is considering a full ban on the payment for order flow (PFOF). The reason is that this practice creates "an inherent conflict of interest," according to SEC Chairman Gary Gensler, in a recent interview with Barron's.
Payment for order flow (PFOF) has become a hot topic in 2021 mainly in relation to Robinhood Markets, Inc. (HOOD), which has enjoyed meteoric success, leading to a highly anticipated initial public offering (IPO). Robinhood has been able to attract a large and growing number of brokerage clients through its practice of charging no commissions on trades. Instead, Robinhood derives its revenues mainly through PFOF, which essentially are rebates from the market makers that execute trades for its clients.
- SEC Chairman Gensler says that considering a PFOF ban is "on the table."
- He is concerned that it makes markets less transparent.
- Bans are in effect in the U.K., Canada, and Australia.
- PFOF is the main source of revenue for Robinhood, among other brokers.
"They get the data, they get the first look, they get to match off buyers and sellers out of that order flow," Gensler said regarding the market makers that pay for order flow. "That may not be the most efficient markets for the 2020s," he added.
Gensler did not indicate whether the SEC has found examples of PFOF causing harm to investors. However, he has mentioned in the past that the U.K., Canada, and Australia are among the countries that have banned PFOF.
"Also on the table is how do we move more of this market to transparency," Gensler remarked. He continued: "Transparency benefits competition, and efficiency of markets. Transparency benefits investors."
Specifically, Gensler is concerned that about half of all trading is now done away from the exchanges, and even some trading on the exchanges is opaque, with systems of rebates that look similar to PFOF. He sees this decline in transparency as working against the goal of maintaining "fair, orderly, and efficient markets."
Congressional Scrutiny of Robinhood and PFOF
The Committee on Financial Services of the United States House of Representatives held a virtual hearing on Feb. 18, 2021, in which PFOF, as practiced by Robinhood, was a major topic of discussion. In general, Democratic members of the committee questioned whether this practice resulted in inferior execution prices for individual brokerage clients, while also expressing concerns that Robinhood's commission-free model encouraged excessive trading that could be injurious to its clients in the long run.
Robinhood CEO Vlad Tenev and Kenneth Griffin, founder of Citadel Securities, the primary market-making firm utilized by Robinhood, asserted that Citadel Securities offers superior execution prices to Robinhood's clients, better than the exchanges. Tenev said that "Citadel offers superior execution quality" and that Robinhood automatically will route trades away from Citadel Securities if other market makers offer better execution. Moreover, he also offered statistics indicating that most Robinhood clients are long-term investors rather than active traders.
Nonetheless, the SEC reached a settlement with Robinhood in 2020 over PFOF. The agency had charged Robinhood with making inadequate disclosures to clients and with receiving a much higher portion of the market maker's spread in its PFOF deals from 2015 to 2018 than did other brokerage firms.
Note that, during the Feb. 18, 2021 hearing, Griffin, Tenev, and the committee members made references simply to "Citadel," without clarifying that Citadel Securities is the corporate entity with the market maker relationship to Robinhood. Citadel Securities is a separate corporate entity from hedge fund Citadel LLC, though with the same business address and same corporate parent, Citadel Enterprises Americas LLC.
Warren Buffett and Charlie Munger Weigh In
During the Berkshire Hathaway Inc. (BRK.A, BRK.B) annual meeting on May 1, 2021, CEO Warren Buffett and Executive Vice Chairman Charlie Munger both offered negative comments about trading apps such as Robinhood in response to a question. Buffett opined that they are adding to the gambling problem in the markets and expressed skepticism about their revenue models. Munger decried these apps as "godawful" and "deeply wrong," adding "we don't want to sell things that are bad for people...[by running lotteries] the states are just as bad as Robinhood." Munger even went as far as to say that the apps "pushed the Mafia aside."