The GameStop short squeeze and trading halt in early 2021 fueled debates around Wall Street hedge funds and retail trading. One of the areas that drew the most attention was the practice of payment for order flow (“PFOF”), which is a popular form of compensation received by the retail trading brokers such as Robinhood. (Alex Rampell and Scott Kupor, Andreessen Horowitz). Shortly after the trading frenzy, the Securities and Exchange Commission (the “SEC”) released a 44-page report on how the short squeeze and trading halt went down, and raised several red flags on retail broker practices in the report. (Yun Li, CNBC). Since then, the SEC’s chair, Gary Gensler, has directed efforts to research and propose a set of rules aiming to make the US retail securities market more transparent and fair. (Lydia Beyoud and Katherine Doherty, Bloomberg Law).

Although the trading halt ignited debates around PFOF, it is a practice brokers have used since the 1990s. (Justin Chretien, Carlton Fields). When brokers receive trading orders from investors, the brokers do not trade the orders themselves, but instead, send them to market makers who will execute the orders by internalizing the orders and profit from the bid-ask spread. (Joshua Kennon, The Balance). The market makers then compensate the brokers with a percentage of the spread. Id. Robinhood, for example, is able to offer zero-commission trades partially because it is compensated by the market makers. (Justin Chretien, Carlton Fields). Even though the market makers pay the brokers a fee to execute the orders, they offered better prices than the exchanges in order to stay competitive. (Bloomberg Intelligence; see Alex Rampell and Scott Kupor, Andreessen Horowitz).

The practice of PFOF has been controversial due to inherent conflicts of interest. (Jeffrey Green, The Balance). On one hand, the brokers are required to provide best execution – an obligation for broker-dealer to exercise reasonable care to execute a customer's order by obtaining the most advantageous terms for the customer – to their clients as required by the Financial Industry Regulatory Authority (“FINRA”) regulation. (Rule 5310, FINRA). Best execution often translates to best price, but it does take timing, speed, order size, and other characteristics into account. Id. On the other hand, the brokers may be incentivized to direct orders to market makers that pay the highest compensation. Id. Last year, largely due to the record retail investor trading volume, brokers collectively earned $3.8 billion from PFOF. (Phillip Stafford, Financial Times). The SEC is concerned that the large volume of retail trading from last year – often more than 970 million shares per day – is stimulated by the retail brokers’ gamification of retail trading apps, including email alerts, awards, and prompts. Id. (See Phil Mackinosh, Nasdaq).  

In December, the SEC issued a cease-and-desist order against Robinhood based on misrepresentations related to PFOF, which eventually led to a settlement. (Release No. 33-10906, SEC). The settlement did not conclude that the PFOF is unlawful. (Jonathan Sack and Bronwyn Roantree, Bloomberg Law). However, the SEC did conclude that Robinhood misrepresented the significance of PFOF as its revenue source, and that it did not comply with its duty of best execution. Id.

Though controversial, the practice of PFOF is not without benefits to the investors. Because a market maker is internalizing the shares traded, it can offer prices better than the exchanges can, meaning better than the publicly available price. (Alex Rampell and Scott Kupor, Andreessen Horowitz). Retail investors who trade small orders are especially benefited by not having to   a commission and can enjoy no account minimum investing. (Chris Matthews, MarketWatch). PFOF allowed many more retail investors to invest and have saved them billions. Id. Ken Bentsen, president and CEO of the Securities Industry and Financial Markets Association (“SIFMA”) stated that “the retail investor is getting a better deal than they ever have.” (Bob Pisani, CNBC).

However, Gensler wants to increase trading transparency for retail investors as he is concerned with retail investors’ understanding as to where money goes when traded on retail trading platforms, particularly apps. Id. The SEC chairman also worries that too much power is concentrated in a few large market makers. Id. Gensler is focused on resolving the issue that many retail investors are “not getting the full benefit of full and fair competition when they put a retail market order in right now.” (Chris Matthews, MarketWatch). Gensler has remarked that the playing field among the different players in the market is far from even. (Lydia Beyoud and Katherine Doherty, Bloomberg Law).

In the previewed regulations, Gensler proposed a market-wide minimum pricing increment, which will limit the market makers ability to price shares in tiny price increments. (Chris Matthews, MarketWatch). The minimum pricing increment will make it much harder for market makers to provide a pricing advantage as compared to the exchanges because the market makers were able to price to much smaller increments when the exchanges could only price stocks to the penny. Id. Additionally, Gensler suggested a separate benchmark for brokers to find the best price for trading orders fewer than 100 shares, which are often retail trades. Id. Further, the SEC may also require retail brokers to submit retail trading orders through an auction process, which would be a transparent process for the market makers to compete on best price. Id. The SEC has not ruled out a complete ban on the practice of PFOF. (Maggie Fitzgerald, CNBC). If the SEC’s proposed changes take effect, they will comprehensively overhaul this market structure for the first time in nearly two decades. (Lydia Beyoud and Katherine Doherty, Bloomberg Law).

Many industry participants have commented on the SEC taking aim at PFOF overhaul. Joe Mecane, the head of execution services of Citadel Securities, commented that “a robust analysis of the data and validating” is needed to ensure that the proposed changes will “actually work in the favor of retail” and will not result in “unintended consequence that actually reduces the experience of retail investors in the market.” (Lydia Beyoud and Katherine Doherty, Bloomberg Law). Doug Cifu, Virtu Chief Executive Officer, stated that the burden is ultimately on the SEC to demonstrate a need for a retail trading market revamp, and that the revamp will actually work better than the current market structure. Id. 

Looking ahead, the brokerage industry and financial firms will be watching the SEC’s next move closely. The alteration of the complicated market system, which has been working well for many retail investors, is no small task. However, the increased transparency and stricter disclosure rules may help to mitigate the inherent conflicts of interest associated with PFOF and ultimately serve investors well by allowing more informed investment decision-making.