The head of the SEC announced that it is considering a ban that will change the market.
The US Securities and Exchange Commission (SEC) may prohibit the payment for order flow (PFOF) scheme used by many online brokers, such as Robinhood. So it was stated in an interview with Barron’s by the head of the regulator, Gary Gensler.
The PFOF model is a fee-for-order flow. The mechanism allows online brokers like Robinhood to offer clients zero commission trading.
Gary Gensler noted that payment-for-order-flow is a controversial practice that the regulator may prohibit shortly. A document already lies on the table. The signing of it may mark the end of the use of PFOF in the US market, the head of the SEC says.
How it works
Having received an order from a client, any online broker using this model does not execute it on the exchange but redirects the flows of client orders for execution to high-frequency funds. Which of them offers more for mediation? He directs the order to get a small profit on the spread. He then shares a percentage of that profit with an online broker.
One of the main problems with payment-for-order-flow is the lack of transparency of this model for customers. So, market makers (HFT-funds) can expose the investor to a transaction price far from the most favourable for him. Nevertheless, it is enough to look at the reporting of Robinhood, and you understand the scale of the use of PFOF in the United States – 80% of the company’s revenue came from the use of this model.
These funds are received data firstly, and they can match buyers and sellers of order flow. Such practice has an apparent conflict of interest.
At the end of 2020, the profit from using the PFOF model by such online brokers as TD Ameritrade, Charles Schwab, E-Trade and Robinhood amounted to $ 2.5 billion. By the end of 2021, we will talk about much more significant amounts due to a considerable increase in the retail segment.
What’s next
No date of the decision on the restriction hasn’t announced yet. However, more details may appear in the coming months.
For most online brokers in the United States, order flow sales represent a relatively small part of their business model – usually less than 10% of their revenue. But for Robinhood, which pioneered zero-commission trading, paying for order flow is essentially the company’s entire business.
Realization of risk
Representatives of the online broker Robinhood, following the results of the financial report for the second quarter, stated that they do not expect the ban introduced. However, if this happens, the company will cope with the situation that has arisen.
In my opinion, an online broker can find a loophole in cryptocurrency trading using this model. So far, they are not subject to official regulation in the United States, which means that it is not completely clear whether the ban will apply to them. Robinhood is likely to be more active in developing its zero-commission offer in this area.
It already sees that the revenue from transactions has shifted towards cryptocurrencies – an increase from 25% to 50% due to the second’s quarter report results. Also, in the percentage of proceeds from the PFOF model, there was a shift from Citadel Securities towards HFT funds registered outside the United States – Tai Mo and Susquehanna. For online broker investors, this only added risks.
About the possibility of realizing regulatory risk for the Robinhood business model some times ago warns. The online broker’s shares fell 7% after publishing an interview with the head of the SEC.
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