Editor’s note: This article was updated on Oct. 12 to clarify the relationship between Robinhood, Citadel LLC and Citadel Securities.
Payment for order flow is currently under intense scrutiny, especially by the U.S. Securities and Exchange Commission. The government body says PFOF leads to a conflict of interest between broker and trader. Its suspicion of the model is so strong, in fact, Chairman Gary Gensler suggested a ban on the practice.
This is in turn opening up a can of worms that the SEC can’t pack back up. E-brokerage Robinhood (NASDAQ:HOOD) and the agency are now involved in a very public show of political posturing and legal threats. Of course, a ban would decimate Robinhood — it stands to lose nearly 80% of its $1 billion in revenue if the SEC gets its way.
Jaime Rogozinski, founder of the infamous r/WallStreetBets subreddit, isn’t worried. The stock influencer and experienced trader has seen it all. He’s made many bold predictions about the future of the market, and as he tells InvestorPlace, he’s firm in his stance that PFOF isn’t going anywhere.
As surprising as Rogozinski’s stance is, given the subreddit’s general disdain for Robinhood, it’s not just a contrarian take. Rogozinski says that Robinhood fills an important niche. Beyond that, he says PFOF simply isn’t a predatory execution model.
Payment for Order Flow: There’s No Free Lunch
Payment for order flow is as controversial as it is confusing. For a retail investor just getting into trading, it might be hard to understand that there are different methods used to execute transactions. Even a more seasoned investor might not fully understand the nuances of PFOF and how brokers use it. Those who have been paying attention to the news surrounding Robinhood and its PFOF model might already be aware of the rampant criticism it faces.
When an investor makes a trade, it’s the brokerage’s responsibility to have that trade executed through a clearing house. Through payment for order flow models, brokerages direct swathes of trades to a particular clearing house in exchange for compensation.
The controversy levied against PFOF lies in FINRA’s requirement of “best execution.” FINRA Rule 5310 requires brokerages to use “due diligence” in deciding the most favorable way to execute a transaction. The rule’s lack of a concise definition of “due diligence” allows brokers to take their own liberties. This can cause big issues.
Critics of payment for order flow say that the model flies directly in the face of the rule. They argue this by saying brokerages find more incentive in compensation than they do in providing efficient execution. In this sense, the compensation a brokerage receives is a kickback in exchange for doing business with a given clearing house. Additionally, brokerages can front-run trades, ordering them in a way that nets them higher profits in execution.
Payment for order flow thus presents investors with a double-edged sword. On one hand, there’s potential for gray-area behavior on the side of the brokerage. On the other hand, Robinhood has used PFOF to revolutionize retail trading by making its platform commission free. It’s worth noting here that it isn’t exactly “free” either.
The model has allowed Robinhood to skyrocket in popularity, and it has forced other brokerages to ditch commissions. It’s a venture which has lined the pockets of its executives as well. Nearly 80% of Robinhood’s revenue comes from money made through PFOF; the fees are just hidden in a way similar to the airline industry’s “baggage taxes.” As the old adage says, there’s no such thing as a free lunch.
r/WallStreetBets Founder: PFOF Helps Retail Traders
Rogozinski certainly feels like one edge of that sword is duller than the other. “I don’t think that there’s this conflict,” he told InvestorPlace in an exclusive interview. “In fact, I think [Robinhood is] actually delivering what they’re promising.”
Before founding r/WSB in 2011, Rogozinski had been trading for many years. “My trading path took me into a technical trading style in which execution matters,” he says of his technique. With a commission-based trade, brokerages emphasize execution, preferring to clear trades with whoever can process it at the determined price. This style doesn’t have the same price slippage that PFOF has by slowing the order of execution.
Of course, when a brokerage employs PFOF, its customers can’t be picky about execution. Since brokerages dictate order flow, there’s always a chance that prices can fluctuate between order placement and execution. Rogozinski still refuses to work with commission-free brokerages because of his preferred trading style. “I still pay for all my trades because the way that I profit, personally, requires me to get that cent, that instance.”
So when Robinhood came about in 2013, the patriarch of the fledgling subreddit was vehemently against its order-fulfillment model. “I believed, at that moment, there’s misalignment, the execution’s not going to be as good.”
“I was saying, ‘PFOF does not align with the brokers’ needs.’ What I was actually saying was ‘PFOF is not aligned with my needs,’” Rogozinski said.
Robinhood, Reddit and a Revolution in YOLO Investing
Rather than laying down the law as founder and chief moderator of r/WallStreetBets, Rogozinski let other Redditors decide. Luckily, the community overruled his distaste for the PFOF model, and it proved to be a gold mine for a new generation of investors.
“What happened after is [Robinhood] created this new demographic of investors, what you’re now calling ‘meme investors,’ whose style requires free trading,” says Rogozinski.
Robinhood essentially allows investors to run wild without paying commissions. For example, box spread trading has become popular among retail traders who no longer have to pay commission fees to create a series of hedged trades. Before PFOF, this two-way style of trading was not exactly budget friendly, requiring a fee on each side of the trade. Now, with fees out of the question, the door is wide open.
The style of trading is seen as a pretty safe one, but r/WSB has its fair share of lore around users making supposedly fool-proof box spread trades and losing a ton of money. This adds a shroud of insidiousness to all of this, considering the fact that PFOF isn’t truly “free” for the user.
Rogozinski is confident that even if brokerages are actually behaving in ways detrimental to traders, it wouldn’t affect r/WSB users. “[r/WSB users are] going for these go-big-or-go-broke YOLO trades in which they very frequently turn $1,000 into $100,000,” he says. “If you take the most famous case at this point, Keith Gill — Roaring Kitty — he took 50 grand and turned it into $50 million.”
Since these users rely on making huge gains on their trades, there’s no reason to worry about front-running, according to Rogozinski.
“Everybody says, ‘there’s no such thing as free trades.’ Of course there’s no such thing as free trades, you’re getting a trade-off. You’re getting a trade-off on the execution [time]. I’m not convinced that there is an incentive conflict. These brokers are promising free trades and democratization, and they’re delivering that.”
Robinhood Turns Investors Sour After Big Squeeze
The recent GameStop (NYSE:GME) saga has turned sentiment around PFOF on its head. The short squeeze of GME stock, prompted by a $50,000 investment by Keith Gill, allowed r/WSB users to squeeze the life out of short sellers and rocket GME stock from $17 to $347 over three weeks.
Rogozinski knew this was a long time coming. In his book, WallStreetBets: How Boomers Made the World’s Biggest Casino for Millennials, Rogozinski laid out his prediction for a “stress test” that would expose the r/WSB style of trading, which Robinhood had bred, to the world.
“I don’t think brokers have done the proper stress tests to withstand stampedes of thumb traders that are not afraid of margin calls,” Rogozinski said. “It was very obvious to me because I got to see r/WallStreetBets grow, I got to see the landscape of the brokerage industry change, I saw the number of instruments available to the retail traders increase. The writing was on the wall.”
While prescient in his warning, the effects of the squeeze have impacted the market in a number of mostly unexpected ways. One such unanticipated event was the halting of GME trading on Robinhood. Another was hedge fund Citadel LLC having to spend billions to help bail out its peer investment firms who were devastated by their short positions. It’s worth noting that Citadel Securities, a company that shares a founder with Citadel LLC, is the largest market-making partner of Robinhood. The GameStop halt called into question the conflicts of interests associated with the PFOF model, although Citadel founder Ken Griffin has testified to Congress that his firms did not communicate with Robinhood prior to the trading halts. Lawmakers have since descended on financial experts and brokerage executives during a long and venomous probe into the practice as a result.
Naturally, that trading halt also led to a number of r/WSB users questioning the very platform that allowed the subreddit to thrive. Users planned boycotts of the app and discussed a massive class-action lawsuit; over 40 total suits have now reached litigation as a result of the GameStop saga. Overall, the message board generally holds a great disdain for the platform now.
When Robinhood reached Wall Street with its public offering in late July, Redditors made known their intent to abstain from the stock or to even short it. Of course, when HOOD stock fell immediately after listing, users celebrated. But much to the chagrin of these users, media outlets are branding HOOD as “king of the meme stocks” due to its trading behavior.
Should Regulators Really Ban Payment for Order Flow?
Does all of this undo Rogozinski’s defense of PFOF? Is it no longer a mode of putting power in the hands of the individual? Do Robinhood’s actions go far enough against users’ interests to justify banning PFOF?
From the sentiment of players like Gensler and some lawmakers on Capitol Hill like Sen. Elizabeth Warren, the answer to those questions is a resounding “yes.”
At the end of 2020, the SEC charged the platform with making misleading statements about its PFOF model and how much of its total revenue the rebates make up. The GameStop saga quickly turned up the heat.
At the end of August 2021, Gensler said the SEC isn’t ruling out a ban on PFOF. Robinhood has publicly rebuked this threat, calling a PFOF ban “draconian” and declaring that it will take the SEC to court were such restrictions ever instituted.
Robinhood’s chief legal officer, Dan Gallagher, says a ban is highly unlikely. Rather, the Robinhood exec goes a step further. He says an SEC probe will “arrive at the conclusion that payment for order flow is undoubtedly an amazingly good thing for retail investors and they’re not going to ban it.”
Robinhood Thinks PFOF Is Here to Stay, r/WallStreetBets Founder Agrees
Rogozinski is also sure that a PFOF ban is out of the realm of possibility. “It’s just posturing, it’s talk,” he says. “It’s getting ready for some negotiation.”
The r/WSB founder is confident that regulators’ desires to keep the market balanced are enough to buoy PFOF, at least for the time being. Regulation can’t happen overnight, he says, especially regulation of such magnitude.
“It’s too difficult of a nut to crack because PFOF is linked publicly to what Robinhood’s doing, but I have no doubt that it’s used in a lot of places and in a lot of applications,” Rogozinski said. “If you mess with [the stock market], it has unintended consequences and it’s an extremely dangerous thing to do. They have to make these changes carefully, slowly. It’s really difficult.”
Rogozinski is correct at least about the mass adoption of the payment for order flow model.
Since Robinhood’s emergence, platforms like E*Trade, Vanguard, SoFi (NASDAQ:SOFI), Charles Schwab (NYSE:SCHW) and many others have employed a PFOF model in some way. Retail investors have come to embrace commission-free trading, and Robinhood forced other brokerages to catch up.
The Murky Future of the Robinhood PFOF Model
So where do we go from here? Rogozinski stands firm that regulation will be lukewarm at best. “They’ll probably go back and forth on TV and talk about these things, and they’ll come up with some regulation that’s symbolic.”
Many r/WSB users disagree with Rogozinski regarding Robinhood’s PFOF model. However, both sides can agree that they want to see action of some kind; whether it be regulation or legal consequences for Robinhood, something will have to give. “I like regulation. I invite it because it legitimizes any process,” Rogozinski says. “[The SEC] molds it, they have their say into how it’s going to work. They need to be constantly updating regulation because technology changes.”
What might regulation of this practice look like? Well, the FINRA rule’s ambiguity makes this a hard picture to paint. Because of the murky existing precedent, the government will have a difficult time regulating payment for order flow.
As InvestorPlace Markets Analysts Thomas Yeung, CFA, predicts, future regulation won’t outright ban the practice, but subvert brokerages’ efforts to market the practice as a free way to trade.
“I doubt it’s going away, because PFOF actually does a legitimate service by shifting execution to market makers,” Yeung said. “These specialists can often get better prices, especially for illiquid assets. However, Robinhood and other ‘free’ trading apps have used it as a way to advertise zero-costs trades, when in fact that’s untrue. The more likely scenario is that the SEC, FTC or FINRA bans brokerages from advertising it, but keeps the trading structure in place.”
A New Path Forward?
The rise of commission-free stock trading brought a new generation of investors to the market. And, it once again demonstrated the power that retail investors can have. These investors spearheaded the GameStop saga… and a series of short squeezes that affected companies from BlackBerry (NYSE:BB) to AMC Entertainment (NYSE:AMC) to Newegg (NASDAQ:NEGG) and beyond.
But with free, democratized trading comes a new set of challenges. Indeed, ongoing debates between investors, brokerages and regulators show that there’s no clear path forward. For now, other brokerages are looking for ways to keep commission-free trading whilst escaping the scrutiny of PFOF.
For example, broker Public is moving away from its payment for order flow model as of early 2021. Around the time investors began to call out Robinhood for its trading halts, Public took a stance against its long-time processing model. The brokerage says it is moving away from PFOF to continue holding itself “to a higher standard of transparency and alignment.” As such, it makes most of its revenue now from a new tipping feature, as well as from interest on security lending and cash balances.
But while Public’s effort is valiant, it doesn’t capture the same crowd that Rogozinski argues Robinhood has attracted. “[Public] want[s] to do traditional, more risk-averse [trading]” he says. “It makes sense for them to say ‘we’re not going to do PFOF, we’re going to pay for these trades to go on the exchange and give better execution.’” This comes in contrast to the meme stock aficionados making huge “YOLO” trades.
While there is an effort among brokerages to find the new “perfect” model, Robinhood will continue with PFOF for now. And it will continue to do that by leveraging a younger demographic who wants to get rich quick… without paying fees.
On the date of publication, Brenden Rearick did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.