Eighty percent of Robinhood's June quarter revenue came from payments for order flow.
Justin Sullivan/Getty ImagesThe retail trading industry got a jolt earlier this week when Securities and Exchange Commission Chairman Gary Gensler said that a ban on the contentious payments that brokerages such as Robinhood Markets rely on to subsidize free trading was “on the table.”
Those dollars, called payments for order flow, are a vital artery in the infrastructure that handles most retail traders’ orders for stocks and options. Industrywide, these payments could reach record levels of $2 billion this year for stock trades, and $4 billion for options trades, according to Bloomberg Business Intelligence. The payments are Robinhood’s main revenue source and help pay for its zero-commission approach that other retail brokers have followed.
But such payments have long stirred controversy and are banned in countries like the U.K., Canada, and Australia. The concern is that the payments could discourage brokers from obtaining the best trading prices for their customers—violating the broker’s duty to get a customer the best execution on a buy or sell order. Gensler wants the SEC to examine whether traders are getting the best deal.
How Payment for Order Flow Works
To understand the debate, it helps to know what happens behind the scenes when you place a trading order at a broker like Robinhood or Charles Schwab (ticker: SCHW). Say someone wants to buy 100 shares of AMC Entertainment Holdings (AMC) through her broker. Brokers like Robinhood pass the order along to a trading venue where it can be matched with orders of other traders seeking to sell the stock. The broker chooses the venue, or market maker, in part by how much it can get paid.
Market makers, in turn, make money by paying less to buy a share than what they can sell it for moments later. Their profit is the spread.
Once upon a time, the market maker handling the trade for an NYSE-listed stock like AMC would be at the New York Stock Exchange. In recent years, however, off-exchange market makers like Virtu Financial (VIRT) or Citadel Securities have taken an increasing share of retail trading volume from exchanges like the NYSE. Those off-exchange operators now process more than half of all retail market orders. That’s because off-exchange market makers give retail traders slightly better prices than the exchanges and pay brokers for the order.
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In exchange, these market makers get small orders from a multitude of individual traders that are less likely to throw them for a loss than are the massive and sometimes complicated moves of savvy institutional traders. The smoother retail trades can even be computerized, so market makers are willing to compete for retail volume.
Virtu says that retail traders saved $3 billion from its “price improvements” in 2020, by giving the traders slightly better prices than what exchanges were quoting.
Order-flow payments are what allowed Robinhood to offer commission-free trading. The payments have soared this year, as individuals banded together on social media to trade meme stocks. SEC reports tabulated by Bloomberg BI show that payments received by Robinhood shot to $160 million in the month of February 2021, well ahead of the $100 million reported by the more established TD Ameritrade.
While Robinhood has built its business on order flow payments, some brokers—notably Fidelity Brokerage Services and Interactive Brokers Group (IBKR)—mostly refuse them.
Impact on Brokers
If payments for order flow were banned, it would impact Robinhood, Schwab (which now also owns the firms TD Ameritrade and TD Clearing), and E*Trade’s owner Morgan Stanley (MS), says Larry Tabb, who founded the market structure consultancy Tabb Group and now works at Bloomberg BI.
“The one hurt the worst will be Robinhood,” Tabb says. “Morgan Stanley and Schwab have a lot more ways of making money.”
Robinhood didn’t respond to queries from Barron’s on its order flow payment receipts. In its latest earnings call, the company said it could adapt to regulatory changes.
It won’t be easy. Robinhood got 80% of its June quarter revenue from these payments. For the first half of 2021, according to its order flow payment reports, it got paid $185 million for equity order flows and $600 million for its option orders. The total for Schwab’s various brokerage operations in the first half was $360 million on stocks and $998 million on options. The industry’s hefty order flow payments on options come from market makers at options exchanges, not the off-exchange firms.
Critics and regulators like Gensler worry that order flow payments create a conflict of interest. There are a number of factors that brokers are supposed to consider when deciding where to route their customers’ orders for the best execution. Among those is the speed of execution, the likelihood of matching the entire order, and—perhaps most important—the price per share obtained on the trade.
Retail brokers have always insisted that order flow payments don’t deter them from routing trades to the markets where they’ll be best executed. They argue that the payments have helped subsidize the steady decline of trading commissions in the last two decades, with Robinhood pulling the industry’s commissions down to zero.
Robinhood has been able to get paid a higher rate than other brokers for its order flows. Bloomberg BI’s data show that in the 12 months ended June 2021, Robinhood received an average of 60 cents for an options contract and 48 cents per hundred shares of an order for one of the large-cap stocks in the S&P 500. By comparison, E*Trade got 45 cents for options and 21 cents for S&P stocks, while TD Ameritrade got 58 cents for options and 17 cents for S&P stocks. Payments for non-S&P stock orders are smaller because those orders are harder to match.
Regulators haven’t always concurred that these order flow payments benefit individual traders. In December, the SEC filed administrative charges alleging that Robinhood had sent its customers’ orders to market makers that executed trades at inferior prices in exchange for unusually high order-flow payments from the market makers. Even after accounting for Robinhood’s free commissions, its customers were left $34.1 million worse off, said the SEC. Without admitting the SEC charges, Robinhood paid $65 million to settle the case and promised to improve its disclosure and execution. The broker had previously settled a regulatory action alleging poor trade execution without admitting the charges.
Possible Side Effects
Off-exchange market makers give price improvements and order flow payments for retail orders because the trades are less risky to handle than institutional orders. That has had the curious effect of giving better trading prices to individual investors than to the big money.
“If all retail orders were put on exchanges, the most likely outcome is that retail traders would be harmed and professional traders would benefit,” says Tabb.
Tabb believes that traders would be best served by improved disclosure of order-flow payments and execution quality, not by discarding the market’s current structure. Otherwise, retail trades will be swallowed up in the flow of big money from mutual funds and hedge funds like Millennium Management or Steven Cohen’s Point72 Asset Management.
“If you kill payment for order flow, then my Schwab order subsidizes Stevie Cohen,” says Tabb. “How is that fair? He’s got better traders, better research, and way better technology. All of a sudden I’m competing against Millennium and the head trader at Fidelity Research.”
Write to Bill Alpert at william.alpert@barrons.com
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