This year’s meme mania, which resulted in the sudden rise in the stock prices of previously unloved names like GameStop and AMC Entertainment , occurred in tandem with a flood of new users signing up for so-called free trading platforms like Robinhood .
But in life, and especially in finance, nothing is ever truly free. The retail-trading frenzy reignited the debate over one of the ways commission-free trading apps make their money: payment for order flow, also called PFOF. Here’s how these payments work: Brokerages like Robinhood sell customers’ trading orders to a market maker offering the best price at the time. Market makers, in turn, execute those trades and make money from the difference between the amount they paid the brokerage and what they sell the stock for later.
The payments have faced scrutiny from regulators who say retail traders aren’t getting the best execution of their trades because of possible conflicts of interest between brokerages and market makers. Brokerages have generally defended PFOF, saying that the revenue model makes trading less onerous for retail traders.
“We have to be really careful not to destroy the good in search of the perfect,” Charles Schwab CEO Walter Bettinger said at an industry conference earlier this month, according to a Wall Street Journal report.
Late last year, the Securities and Exchange Commission fined Robinhood $65 million for failing to properly disclose to users how it made money between 2015 and 2018. The agency also found the trading platform’s execution on trades was worse than Robinhood was telling clients during that period, costing customers $34.1 million. Robinhood settled without admitting or denying wrongdoing.
But that discussion over PFOF has been reignited under new SEC Commissioner Gary Gensler told Barron’s in August that eliminating PFOF was “on the table” and that it has an “inherent conflict of interest.” Gensler said market makers get the first look at trades, something few other market participants receive.
For their part, market makers wouldn’t necessarily be opposed to the end of payment for order flow.
“Payment for order flow is a cost to me,” Ken Griffin, founder of Citadel Securities, one of the largest market makers, said at the Economic Club of Chicago in October. “So if you’re going to tell me that by regulatory fiat one of my major items of expense disappears, I’m OK with that.”
To be sure, few retail investors are fully aware of the hidden costs they may incur. And for the types of trades most retail investors engage in, some of those price discrepancies may not even add up to a penny. The issue, critics argue, comes down to market transparency.
“Transparency benefits competition, and efficiency of markets. Transparency benefits investors,” Gensler told Barron’s in August.
While it’s difficult for the average investor to test how their trades are being executed, I thought I’d give it my best shot in this episode of Unboxed. I placed identical orders at the same time for five shares of the same stock on two different trading apps: Robinhood, which collects nearly 75% of its revenue from PFOF, and Fidelity, which doesn’t engage in PFOF.
Did I see a difference in my trading? Watch to find out. And don’t forget to subscribe to my YouTube channel here to watch new episodes when they appear.
Write to Carleton English at carleton.english@dowjones.com
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November 30, 2021 at 10:29PM
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How Much Does Payment for Order Flow Cost You? We Did an Experiment. - Barron's
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