Robinhood’s stock has dropped more than 50% this year amid concerns about its profitability and the economy, and new SEC regulations could put its largest revenue source in jeopardy. SEC Chairman Gary Gensler is reportedly planning to give a speech Wednesday that will outline potential proposals to curtail payment for order flow (PFOF), according to a recent Wall Street Journal report. Zero-commission investing apps such as Robinhood make their money through PFOF, which consists of routing retail investors’ trades through “market makers,” or large, sophisticated trading firms like Citadel Securities that execute the transactions.
Market-making firms pay Robinhood hefty fees–to the tune of more than $1 billion in 2021–that made up more than three-quarters of Robinhood’s revenue last year. Trading firms shell out big bucks for the right to execute these orders because they can profit from them by shaving small fractions off bid and offer prices.
Over the past 50 years, the cost of trading stocks for retail investors has fallen dramatically. In the 1980s, average commissions sat at over 1 percent of a trade’s value, or close to $45 for the average trade. However, average trading costs decreased dramatically since then, falling by half by 1990 and to less than $15 by 2000. In 2013, though, Robinhood revolutionized retail investing by introducing a zero-fee trading platform that eliminated trading fees entirely. No-fee trading has since become the industry standard: in 2019, established players like Charles Schwab and TD Ameritrade followed suit and eliminated all trading fees from their platforms.
PFOF has been around since the 1990s but has come under increased scrutiny in the past few years as no-fee investing platforms’ popularity has exploded. And the question of whether it hurts retail traders or unfairly benefits some companies has been hotly debated. Critics argue that brokerages like Robinhood are incentivized to seek profits by routing customers’ trades through specific market makers rather than shopping for the best option for its customers. That limits competition for stock orders and results in consumers getting worse prices for their transactions, critics say. Notably, Robinhood competitor Public abandoned PFOF in favor of voluntary tips on their no-fee investing platform in February 2021, citing transparency concerns. Last year Gensler said PFOF presents “an inherent conflict of interest,” adding that the trading firms “get the data, they get the first look” at retail investors’ planned trades before they hit the market.
Yet a recent academic study indicated that “PFOF has saved retail investors billions in unnecessary fees.” Robinhood has written that “there’s no incentive for us to route your order to any specific market maker based on payment we receive” and that its system gives users “a better price than the one you were quoted at the time your order was placed.” A Citadel Securities spokesperson says, “It is important to recognize that the current market structure has resulted in tighter spreads, greater transparency, and meaningfully reduced costs for retail investors. We look forward to reviewing the proposals and working with the SEC and the industry towards our longstanding objective of further improving competition and transparency.”
In December 2020, the SEC fined Robinhood $65 million for failing to sufficiently review the execution quality of its users’ trades, resulting in certain customers paying worse prices, and for misleading consumers about its PFOF practices. Robinhood didn’t admit or deny wrongdoing, and its chief legal officer Dan Gallagher said at the time, “The settlement relates to historical practices that do not reflect Robinhood today.”
When Robinhood was getting ready to go public last year, it warned that regulatory actions could put its PFOF-based business model at risk. “Any new or heightened PFOF regulation may result in increased compliance costs and otherwise may materially decrease our transaction-based revenue,” the company stated in its S-1 filing. “The practice of PFOF may be limited substantially by new or revised laws or regulations, which would materially decrease our transaction-based revenue, or banned entirely, which would require us to make significant changes to our revenue model, and such changes may or may not be successful.”