The U.S. Securities and Exchange and Commission (SEC) is considering a full ban on a controversial practice in the brokerage industry, known as payment for order flow (PFOF), according to Chairman Gary Gensler, who was recently interviewed by Barron’s.

On Aug. 30, the day Barron’s published the interview, Robinhood Markets (NASDAQ: HOOD) stock plunged nearly 7% to finish at $43.64.

The company made its Wall Street debut in late July and has risen almost 25% since the IPO, according to data compiled by Refinitiv.

This post will talk you through payment for order flow, how this practice works, Robinhood’s business model, and how a ban on PFOF could affect the popular brokerage app.

So, without further ado, let’s jump right in.

About Robinhood

Robinhood is an online brokerage firm that was co-founded in April 2013 by Vladimir Tenev and Baiju Bhatt.

It was the first broker to offer commission-free online trading for U.S. stocks and exchange-traded funds (ETFs), a move that saw traditional brokerages Charles Schwab (NYSE:  SCHW) and E*Trade feel the heat and follow suit in 2019.

Part of Robinhood’s success has stemmed from efforts to make investing fun (gamifying its app) to stimulate trading and attract both millennials and Gen Z.

Robinhood also allows investors to access the retail market, including initial public offerings, and has enabled its users to trade in assets like cryptocurrencies.

But critics and regulators argue that Robinhood and other brokers that gamify their trading apps have turned the stock market into a game, which amateur traders are too eager to play without first knowing what is at stake and understanding the rules.

All in all, Robinhood’s zero-commission model and its user-friendly app, have made trading much easier and cheaper for ordinary traders, irrespective of their experience, attracting more than 21 million monthly active users at the last count.

What is the meaning of “payment for order flow”?

Payment for order flow, or PFOF, is a controversial and complicated practice done by brokerage firms such as Robinhood and Charles Schwab, whereby they accept money (typically, fractions of cents) from “market makers” in exchange for routing client trade orders.

The whole idea of commission-free trades is tied to payment for order flow. First, a trader submits a sell or buy order for stock through Robinhood or another online broker.

The broker then passes that order along to a third-party market maker. Market makers are typically large banks or institutions that provide liquidity to the market by offering to both buy and sell securities in large orders.

After receiving the receiving, the order, the market maker pays the broker a small fee.

Once the market maker executes the trade, it buys the shares at a discount to the price at which it sells them, pocketing the difference as profit. That difference is known as the “bid-ask spread.”

Robinhood and other trading platforms have figured out that they can make more money selling customer orders in the current climate than by charging small fees directly to customers for each trade.

They argue that payment for order flow provides better prices for traders and has opened up new markets. However, some regulators and consumer advocates criticize the practice, claiming that it presents an inherent conflict of interest.

By the way, did you know that payment for order flow was pioneered by the late Ponzi scheme king Bernie Madoff in the 1990s?

How a ban on PFOF could affect Robinhood

Since Robinhood does not charge its users commissions to trade, it gets most of its revenue from payment for order flow.

In its second-quarter earnings report, the first since going public, Robinhood revealed a loss of $502 million, compared with a profit of $58 million from the year-ago quarter.

The broker said a huge chunk of that loss was as a result of warrants from an emergency funding round it raised this year.

However, it grew 131% to $565 million during the second quarter from the $244 million it had during the same period last year.

According to the report, Robinhood derived around 80% of the revenue from PFOF, or payments it received for routing orders for stocks, cryptocurrencies, and options to market makers.

Based on these financial results, it’s very easy to conclude that a ban on payment for order flow, could have a detrimental impact on Robinhood’s revenues.

Gensler told Barron’s that PFOF has “an inherent conflict of interest” and that a full ban of the model “is on the table.”

The SEC boss also added that on top of making a small spread on each trade, market makers also receive data, the first look at a trade, and the ability to match traders from the order flow they get from brokerages.

While Gensler didn’t state whether the SEC officials had found cases where investors had been hurt by conflicts of interest, he warned that PFOF “may not be the most efficient for the 2020s.”

Bottom Line

Robinhood has been one of the biggest winners during the Covid-19 pandemic, thanks to its simple and user-friendly trading app that has made it easy to trade stocks, options, and even cryptocurrencies.

Earlier this year, the app greatly contributed to wild moves in so-called meme stocks such as GameStop (NYSE: GME), AMC Entertainment (NYSE: AMC), and BlackBerry (NYSE: BB).

But Robinhood also faced extreme criticism at the height of the meme-stock trading frenzy as the broker and some of its rivals restricted trading of certain stocks because of increased capital requirements from clearinghouses.

During a February congressional hearing about Robinhood’s meme-stock trading debacle, a number of lawmakers focused on PFOF, blaming it for the broker’s decision to block trading of some stocks.

Now, it remains to be seen what Robinhood will do as SEC looks into PFOF over concerns the practice may incentivize brokerages to sell customer orders to market makers that maximize their own profits instead of making it easy for its customers to execute their trades.

One thing is certain, however: Robinhood and its peers would have to start charging commissions to avoid going if the SEC announces a full ban on PFOF.

According to this Bloomberg article, the whole Robinhood era of excitable retail trading, meme stocks, and options-driven price moves would be gone forever.