Order flow sales/Robinhood: no free lunch

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The GameStop saga has turned the spotlight on the low-cost trading platforms which have allowed millions of ordinary Americans to trade stocks easily. Regulators are now expected to scrutinise the practice that finances the zero-fee business model of key broker Robinhood: selling order flows to other Wall Street businesses.

Payment for order flow, or Pfof, involves exchanges or market-making companies such as Citadel Securities or Virtu Financial paying brokers for the right to execute orders for their clients. It is big business. US brokers collected almost $3bn in such payments last year. 

Proponents say the system lowers trading costs for small, retail investors and allows them to get better prices. Individual investors opened more than 10m new brokerage accounts in 2020, according to JMP Securities.

Critics say the arrangement sets up an inherent conflict of interest. Brokers could be tempted, these critics claim, to route orders to firms that pay the most for them. That could collide with an overriding US legal duty to get clients the best price on their trades. Robinhood just recently faced a Securities and Exchange Commission enforcement action on this issue.

But meeting that duty is complicated by the existence of multiple exchanges and trading platforms. For many brokers, it is easier to deputise the job to a middleman such as Citadel Securities. 

This is a market maker, a breed that covets small buy and sell orders, which are easy to balance. They are willing to offer narrow spreads when these arrive in bulk. Profits are slim, often a fraction of a cent. But they add up if you are executing millions of trades.

There is meant be an impenetrable Chinese wall between dealings for clients and proprietary trading at market makers, to stop exploitation of client data. Worldwide, brokers and market makers have a historic record of front running — buying and selling for themselves to profit from price moves triggered by client orders placed afterwards.

US regulators now have their work cut out. They need to trawl through oceans of price data to check the principle of “best execution” is being honoured. They must test the robustness of Chinese walls. And they should require hidden costs to clients to be disclosed.

Watchdogs must also confront two far trickier questions. Are clients of zero-fee brokers actually paying in data, as social network users do? And does this twist economic incentives in a way that is unacceptable? For Robinhood and its backers, the answers could be painful.

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