Are brokerage commissions fooling you? The SEC doesn’t think so: Morning Brief

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September 23, 2022

Today’s newsletter is from Julie Hyman, host and correspondent of Yahoo Finance. Follow Julie on Twitter @juleshyman.

Who else is sick of talking about the Fed? Of course, the Federal Reserve and its battle against inflation by using higher interest rates is vital. But I need a break.

So, on another crucial question: are zero commission brokers screwing you?

The Securities and Exchange Commission is apparently deciding that they are not, or at least that the SEC will do nothing about it even if it is. Bloomberg reports that the agency has decided not to ban payment for the order flow, known as PFOF. This is a practice where brokers process client trades through wholesalers, in a way that critics say they impose hidden fees on individual traders.

The argument against PFOF is that the practice poses a conflict because, in theory, brokers should aim to make money for their clients, not market makers like Citadel Securities. In fact, it’s hard to find many in favor of a total ban on PFOF aside from the meme buffs who populate Twitter and Reddit. Rather than ban the PFOF, the SEC would be wise to focus on price transparency and require brokers to execute trades at the best possible price at that time.

“The SEC must not prohibit payment for order flow or other specific market practices against investors and in conflict if it requires best execution to be the best available price at the time, given the characteristics of the order and market conditions. “Dennis Kelleher, head of investor advocacy group Better Markets, told Yahoo Finance in an email:” If it does, the SEC won’t have to play braggart with an industry that’s relentless at creating. new wealth extraction practices that avoid yesterday’s rules and require new rules tomorrow “.

A crucial revenue stream for commission-free intermediaries

In a PFOF model, a commission-free broker like Robinhood or Schwab processes an investor’s order to buy stock and passes it on to a wholesaler, such as Citadel Securities or Virtu Americas. These market makers then execute the transaction and pay the brokerage firms to route the trade through them.

When the market maker can buy a share at a price lower than that requested by the client, the broker and the market maker share the savings. The money pocketed by the middlemen, the “order flow payment”, can fund his business without commissions.

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

This is a major revenue stream for Robinhood, which popularized the practice in 2020, when US households were full of stimulus controls and ready to play the market. Since then, trading on Robinhood has declined, along with the share price, and has sought to diversify revenue streams.

According to JMP Securities analyst Devin Ryan, PFOF accounted for 9% of Robinhood’s equity revenue last quarter, 36% of options revenue, and 18% of cryptocurrency revenue. The company’s stock rose based on the report that the SEC had no plans to institute a ban. However, Robinhood then erased that gain and closed 2.72% lower at $ 9.65 per share, much less than this time last year, when it was trading five times as much.

However, it is clear that the Bloomberg report on the SEC’s decision regarding the PFOF is good for Robinhood. Does this gain come at the expense of small investors?

Trading companies, predictably, think there is no problem with the current system and argue that retail traders are already getting good prices. SEC Chairman Gary Gensler largely took the other side, saying in June that paying for order flow “can skew routing decisions.”

However, experts argue that eliminating PFOF would attack the wrong issue. The problem, according to a recent study by several business school professors, is the hugely different prices retail investors can pay depending on the market maker who routes their orders. The study found that differences between brokerage platforms and where an order is routed can cost small investors up to $ 34 billion annually.

Watch: How does the payment for order flow work?

The solution to this problem is not getting rid of PFOF, according to Christopher Schwarz, a professor at the University of California Irvine, co-author of the study. Instead, he said, brokers should be more transparent about pricing.

The PFOF ban debate “is the bright thing in the room that distracts everyone from the issue of market centers giving very different executions to different brokers. And that execution is unrelated to the PFOF, ”Schwarz wrote to Yahoo Finance on Thursday.

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

“The United States has the deepest and most liquid capital markets in the world, but we may not do it if regulators get too involved,” he wrote. “As long as competition exists, things will get better and trading costs will drop further.”

Undoubtedly, many on Wall Street agree with Dillian, and newspapers like Schwarz’s may have influenced the SEC to look at the matter differently. Of course, the agency could end up banning the PFOF or limiting it. In the meantime, it’s hard to tell if investors are mad at PFOF or just plain wary of the market these days.

The number of people trading through Robinhood has dropped this year, to 14 million monthly users transacting by June 2022 from 17.3 million last December. As Robinhood’s user base has shrunk, alternatives have emerged, including Public.com, which is commission free, does not offer payment for order flow and instead allows users to tip brokers who execute their operations. The company says its users have grown from 1 million in mid-2021 to 3 million in early 2022.

Ultimately, the PFOF could fall out of favor, regardless of whether the SEC steps in to oversee the practice.

What to watch today

Economic calendar

  • 9:45 am ET: S&P global manufacturing PMI in the USPreliminary September (51.1 expected, 51.5 during the previous month)

  • 9:45 am ET: Global PMI of US S&P servicesPreliminary September (45.0 expected, 43.7 during the previous month)

  • 9:45 am ET: S&P global manufacturing PMI in the USPreliminary September (46.0 expected, 44.6 during the previous month)

I earn

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