By: Darshan Nandha and Ehigie Okotako
Payment for order flow (PFOF) is a compensation method for a brokerage that receives payment for bringing order flow for a third party (market maker) to execute. The brokerage receives a small payment for each trade they bring to the market maker for them to execute the trade at an inferior price and profit from the difference between the price that the order is demanding and the market price. This allows the user to avoid paying commission upfront, however they do execute trades at worse prices relative to other brokerages that do not use PFOF. An example of this situation in practice: a user places a trade to buy 1 share of APPL at $150 through a brokerage that uses PFOF. This trade would be sold to a market maker and they would buy the share at $149.98 and sell it to the user at $150, thus not giving the best price possible for the user.
Robinhood is currently under fire for these practices, which entail selling the order flow of its customers to market makers. In a February 2021 survey, nearly 56% of account holders were considering leaving the app (Haederle 2021). This allows them to offer “free” trades to uphold the image of a zero-comission stock brokerage. Their main investors, millennials and first-time traders, believe they aren’t paying anything while in reality Robinhood profits off their trades and keeps these fees hidden. This is a failure by Robinhood to fulfil their fiduciary duties of seeking the best prices for its users. The average investor is probably unaware and does not see the significance because they don’t know otherwise. Moreover, generating roughly 800 million per annum shows a lot of money being swept under the rug.
Due to the lack of compliance with their fiduciary duties, which entails seeking the best prices for their users, this led to an aggregate loss of $34.1 million for their users (SEC 2021). The SEC is considering banning this revenue model that Robinhood has in place, which could hinder the 84% of revenue PFOF generates for Robinhood. This legal action would affect over 80 million users in total by enforcing Robinhood, Charles Schwab, E-Trade, TD Ameritrade and other zero-commission trading platforms. Due to the nature of most traders being first timers or just millennials, they are unaware of these charges and continue to trade because they do not see the direct implications of PFOF. Although this is public knowledge, this is an example of asymmetric information and users of this application should be informed. If all users were educated this would influence the number of Robinhood users which would also decrease their total revenue.
On December 17, 2020, the SEC charged Robinhood with repeated misstatements that failed to disclose the payments for routing orders to trading firms and failure to fulfil their fiduciary duties of seeking the best terms of execution for their users. This ultimately led to Robinhood being charged $65 million (SEC, 2021). Following these charges, Robinhood persists and continues to use a PFOF model and justifies it by their National Best Bid Order (NBBO) or better rate of 96.79%. This controversy has sparked a debate between Robinhood and the SEC resulting in further investigations. The large aggregate loss of retail investors' capital is another driving force for the SEC to proceed with investigations. Robinhood continues to argue that they are providing the best execution prices for their users, although the SEC believes otherwise. If the latter is proven, during these investigations, Robinhood will be subject to more lawsuits and this could potentially lead to the prohibition of PFOF business models, as hinted by SEC Chairman Gary Gensler (CNBC, 2021).
These platforms should not use PFOF and instead follow the business models of commission free brokerages in Canada and Europe where PFOF is banned. These brokerages charge non-trading fees such as currency exchange, withdrawing, inactivity etc. fees. Allowing PFOF brokerages to avoid lawsuits and carrying the risk of losing a large portion of their revenue if PFOF is banned.