By Amanda Maine, J.D.
While much of SEC Chair Gary Gensler’s recent testimony before the Senate Banking Committee involved spirited back-and-forth conversations about the SEC’s role in regulating cryptocurrency and mandating ESG disclosure, the debate about payment for order flow (PFOF), especially in the wake of recent market volatility involving mobile trading apps, was also a hot topic. While Gensler and some investor advocates have voiced concern that payment for order flow can cause conflicts of interests regarding best execution, others maintain that allowing payment for order flow empowers retail investors by making zero-commission trading more available to those not traditionally involved in the market.
Payment for order flow. As defined by the SEC in a 2000 study, PFOF is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution. The practice is currently legal in the U.S., although Regulation NMS requires brokers to disclose their policies surrounding this practice and publish reports that disclose their financial relationships with market makers. The practice is banned in some jurisdictions, including the United Kingdom, Canada, and Australia.
PFOF has been criticized as creating a conflict of interest in brokers’ best execution obligations to their clients. For example, in 2014, the late Sen. Carl Levin wrote to then-SEC Chair Mary Jo White urging the Commission to prohibit PFOF, arguing that these payments create an incentive for brokers to maximize their own profits at the expense of best execution of customer orders.
PFOF has come under more scrutiny lately following the GameStop-related market volatility earlier this year. Three congressional hearings examined the volatility spurred by trading through the Robinhood mobile app, which does not charge commissions for trades but does use PFOF. In his testimony at the third hearing, Gensler noted that many retail broker-dealers, including popular trading apps like Robinhood, have stopped charging fees for trades but instead make money through other streams, including payment for order flow. As a market structure issue, Gensler expressed concern that this practice raises questions about whether broker-dealers have inherent conflicts of interest and whether customers are getting best execution in the context of that conflict. He also advised that he as directed the SEC staff to look into the practice of PFOF.
Others have dismissed these concerns and have criticized the possible prohibition of PFOF as more SEC meddling in the free market that has become increasingly “democratized” by apps that are user-friendly to retail investors. Representative Patrick McHenry (R-NC), ranking member of the House Financial Services Committee, has criticized calls for banning PFOF, which he said has benefited retail investors because it has resulted in zero-commission trades. SEC Commissioner Hester Peirce has also taken a cautionary note about banning PFOF, instead voicing support for mandating better disclosure of the practice. In Peirce’s view, banning the practice would result in an increase of costs to investors who benefit from PFOF.
PFOF: Helping or hurting retail investors? At his most recent appearance before the Senate Banking Committee, Gensler testified about a number of issues, including the regulation of cryptocurrency and environmental, social, and government disclosures (see Securities Regulation Daily, September 14, 2021). Senators also quizzed Gensler about his views—and possible SEC action—on PFOF. Gensler restated that he has asked the staff for recommendations on how to ensure a more level playing field in the market, to enhance competition, and to improve resiliency, including examining how conflicts of interest arise under PFOF.
Expressing similar concerns to Gensler regarding PFOF, Sen. Jack Reed (D-RI) called out possible conflicts of interest resulting from PFOF arrangements. While acknowledging the benefits of increased investor participation in the stock market through discount brokers who provide access to the market with zero commission, Reed said that many of these brokers have deals with high-frequency trading firms in exchange for rebates which will send the orders to these firms. Reed inquired if the owner of the security is getting the best deal or is the intermediary getting a lot of money.
In response, Gensler noted that it has been 16 years since the SEC did a rewrite of the national market structure, and PFOF may make U.S. markets less efficient because retail investors may not be getting best execution even if they get price improvement in the form of paying zero commission on trades. According to Gensler, for investors in the retail market, there is a 97 percent chance it does not go to a transparent exchange. Instead, it goes to the dark markets or to the wholesalers, where it is harder to get best execution when you are not competing order-to-order, he explained.
Senator Thom Tillis (R-NC) was not as sympathetic to Gensler’s views on PFOF. He inquired whether potential conflicts could be mitigated by a safeguard where retail brokers can cure potential conflicts of interest; that is, where execution partners pay same rate and act within the same system by essentially putting all execution partners in competition with one another on execution quality and not on payment for order flow.
According to Gensler, the challenge exists where one party is buying all or the bulk of the order flow, then the order-by-order competition doesn’t exist, so the retail public does not benefit from that competition. “If one party is buying literally half the retail flow in America, that can actually diminish competition in the marketplace,” Gensler advised.
In his opening statement at the hearing, committee Ranking Member Sen. Pat Toomey (R-Pa) also took aim at Genlser’s remarks on restricting PFOF. According to Toomey, such a move would be a “paternalistic” effort to restrict investor freedom under the guise of protection. PFOF allows for commission-free trading by retail investors by permitting a broker to keep a portion of the price improvement obtained by routing a transaction to a wholesaler, he remarked. Banning PFOF could have the effect of eliminating commission-free trading, Toomey continued, which would be a “grave disservice to average investors.”
Toomey also criticized Gensler for characterizing trading apps that “make investing easy and fun” as “gamification.” These kinds of technological improvements make today the best time ever to be a retail investor, Toomey said, citing commission-free trading, accounts with no minimum balances, low- or no-fee mutual funds and ETFs, and user-friendly technology like mobile apps. Toomey also said that investors are free to choose a broker that does not use PFOF but does choose to charge a commission. “Adults investing their own money should be free to choose how to do so,” Toomey proclaimed.