What happens to Robinhood, Schwab if SEC bans payment for order flow?
June7,2022
What would happen to brokerages like Robinhood (NASDAQ:HOOD), Charles Schwab (NYSE:SCHW), Morgan Stanley's (NYSE:MS) E*Trade, Webull, and Monex Group's (OTC:MNXBF) (OTCPK:MNXBY) TradeStation if the Securities and Exchange Commission decided to prohibit payment for order flow?
Note that brokerages generate payment for order flow, known as PFOF, as compensation for directing retail orders to market makers like Citadel Securities for trade execution. In simpler terms, PFOF provides brokerages with revenue.
The PFOF-ban question comes to mind after a report that the SEC is considering making trading firms directly compete to execute trades from retail investors, though no decisions have been made yet.
SEC Chairman Gary Gensler is expected to outline some proposals this fall, including requirements that retail orders are sent to a type of auction to improve execution transparency, lower access fees and allowing stock exchanges to quote shares in increments under one cent, The Wall Street Journal reported Monday. He'll also call for improvements to execution rules, that allow brokers to find the best possible terms for their customers.
An auction construct on retail orders could lead to trading firms "cherry-picking which orders to fill and/or possibly further internalization, neither of which is consistent with the SEC’s overarching policy goal," BTIG analyst Isaac Boltansky wrote in a note. Opponents of the auction construct proposal would likely point out that, if approved, it could end the commission-free trading paradigm that has expanded access to equity markets, the analyst added. In other words, retail brokers would have to start charging transaction fees again to make money since they wouldn't be getting paid for order flow.
The proposals on tick sizes and access fees "are intended to modernize the marketplace and lead to more volume being routed to exchanges," Boltansky explained. "Efforts to modernize the best execution requirements will be met with some degree of conceptual support, but this issue carries slightly more political and operational baggage than the tick size and access fee proposals."
Overall, "most of these proposals should be able to move forward with little resistance, but we are bearish on efforts to introduce an auction construct for retail orders and thereby believe that payment for order flow is likely to remain," Boltansky noted.
Meanwhile, market-making firm Virtu Financial (NASDAQ:VIRT) shares fell 2.3% in Tuesday trading, "as some investors believe the auction model could increase competition and allowing exchanges to quote shares in increments under $0.01 could tighten spreads for lower priced stocks as well," Compass Point analyst Chris Allen wrote in a note. "Our gut reaction is that this could have a negative impact on certainty of retail execution, particularly during periods of market turmoil. Also, if the model does shift towards an auction model, VIRT would likely be a key participant and potentially save on PFOF payments."
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