SEC could cripple Robinhood’s business model by enforcing existing rules, experts say
Online brokerage Robinhood has sparked bipartisan anger in Washington after it unexpectedly restricted purchases of GameStop, Inc. and other hot stocks, and this attention could prompt regulators to restrict its industry on more profitable, experts told MarketWatch.
While public outrage has focused on the conspiracy theory that Robinhood has blocked purchases of GameStop GME,
and other actions to help Citadel Securities – one of its largest sources of revenue and a sister company to the Citadel hedge fund – known facts support Robinhood’s claim that its actions were taken to reduce the risks faced with guarantee requests from the clearing house that executes its transactions.
At the same time, Citadel Securities said in a statement last week that “Citadel Securities has not instructed or instructed any brokerage firm to stop, suspend or limit trading or otherwise refuse to do business “.
See also: Lawsuits See Plot In Robinhood’s GameStop Moves, But Pundits Doubt Narrative
But with Robinhood CEO who should have testified before the House Financial Services Committee and Treasury Secretary Janet Yellen set to set up a meeting with key federal regulators to address last week’s events, the broader implications of the Robinhood’s connection with Citadel Securities could come to light and force the Securities and Exchange Commission and the Financial Industry Regulatory Authority to rule over the practice of payment for order flow, whereby market makers pay brokers for the privilege to execute investor transactions.
“The SEC and FINRA have inexplicably allowed payment for the flow of orders for years,” said Tyler Gellasch, executive director of Healthy Markets, a nonprofit consortium of pension funds that advocates for investor rights.
Gellasch said it was difficult to reconcile the practice of stockbrokers of selling the right to trade against its clients with “best execution” regulations which essentially require brokers to find the best price for their retail clients. .
Market makers have huge upfront costs, including technology, infrastructure, data, and payment for orders (PFOF), he said. “After these four expenses, they still make a profit from trading against a client even though they themselves have no significant financial exposure for a period of time.”
Noted venture capitalist Bill Gurley also drew attention to the practice in a series of tweets on Sunday, where he pointed out that even Citadel itself was once against the practice, when he told the SEC in 2004 that PFOF “creates a clear and substantial conflict of interest between brokers and their clients”.
Nonetheless, paying for order flows has been a practice that US regulators have tolerated for over thirty years, and a sudden change in its stance towards it is unlikely and would be subject to legal challenge, according to Amy Lynch, a former regulator. of the SEC and President of FrontLine. Conformity.
“Paying for order flow is nothing new,” she said. “The practice itself is widely accepted, widely used and completely legal. ”
Gellasch argued that although the practice was deemed legal, it remains controversial and is subject to scrutiny by a Congress which in some ways has grown even more skeptical of Wall Street since 2014, when the Former Senator Carl Levin has held hearings on this and recommended regulators. prohibit it.
The SEC “must prevent brokers from accepting payments to route their clients’ orders to certain traders and exchanges,” Michigian Democrat wrote in an editorial in the Financial Times last month. “It’s like paying a private, hidden tax on savings, whether someone invests through a large mutual fund or directly through a personal brokerage account. “
Since the 2014 hearings, FINRA has issued more guidance and participate in targeted reviews to better understand the impact of order routing incentives on execution and found that some brokers were not engaged in regular analysis of their orders to ensure that clients, on average, were getting the best price and best execution.
Robinhood struck a deal with the SEC in December after the regulator said that between 2015 and 2018 Robinhood made misleading statements about its incentives for ordering and that a fraction of its customers did not. received the best price on their orders, a failure that cost them $ 34 million compared to what they would have paid had they used other brokers who were charging $ 5 commissions per trade.
Robinhood settled without confirming or denying the charges and said in a statement when the “settlement relates to historical practices that do not reflect Robinhood today,” and that it has since changed its order routing protocol to ensure the best execution.
Dr Richard Smith, founder of TradeSmith and CEO of the Foundation for the Study of Cycles, argued that Robinhood may not have come out of the woods yet, given that it is still engaging in practices of pay-to-order which particularly encourage the broker to offer illiquid products and risky investments.
Robinhood says on its website that it structures its market maker discounts as “a percentage of the bid-ask spread, or the difference between the highest buy price and the lowest price to sell the market. action, at the time of execution “.
“Now think of all the call options purchased by WallStreetBets / Robinhood users at some of the widest spreads ever seen in history or the markets and notice how this is the best thing that can happen to Robinhood in terms of payment method. Smith told MarketWatch.
Public data shows that Robinhood won a lot more per share for its discounts in the fourth quarter of 2020 than its competitors Charles Schwab Corp. SCHW,
or MS from Morgan Stanley,
E-commerce. Robinhood did not immediately respond to a request for comment on its rebate structure.
Devin Ryan, analyst at JMP Securities, wrote in a note to clients earlier this week that despite the unease around perceived conflicts of interest over the payment of order flow, “brokerage services tend to win between less than a dollar and up to two dollars per transaction, significantly less than the brokerage firms used to bill clients over the years. ”
Despite what Ryan sees as a model that has benefited the average investor, he said he wouldn’t be surprised if Congress and regulators carefully scrutinize these arrangements in the years to come.
If regulators decide to reduce the discounts on order routing, “we think ultimately that many of these companies would be looking to incorporate in-house market making activities, like Fidelity and a few others,” he said. he writes. “It would take a while to put in place, but we believe there are too many stakes and internalization of trading would be a qualifying solution which could lead to a rush to create or purchase outfit features. Steps.”