Why it could be tough for the SEC to ban payment for order flow

·4-min read

Securities and Exchange Commission Chair Gary Gensler said during Yahoo Finance’s All Markets Summit on Monday that the agency is exploring avenues to rein in payment for order flow, a practice increasingly driving revenue for brokerage firms and retail trading platforms that offer commission-free trades.

Gensler’s comments to Yahoo Finance's Brian Cheung, which echo those made to Barron’s in August, suggest that the agency has legal grounds for imposing such regulation.

“I've really said to staff, look, payment for order flow, and what we do with that, whatever restrictions, is on the table,” Gensler said when asked if the SEC has legal authority to ban the lucrative practice. “But also we're looking at things that are within the market structure itself.”

Payment for order flow is a practice in which market makers like Citadel Securities execute trades for customers of brokerages like Robinhood. The market maker makes a small profit on individual trades that add up to larger revenue streams, en masse, while the brokerage earns a fee for sending the trade its way.

In 2020, payment for order flow revenue for the top four brokerage firms — TD Ameritrade, Robinhood, E*trade and Charles Schwab (SCHW) — nearly tripled, jumping from $892 million to nearly $2.5 billion, according to Data from Alphacution previously cited by Yahoo Finance. The revenue stream became the target of increasing scrutiny as retail trading platforms increasingly relied on the funds to offset “zero-commission” trades.

'The authority is not clear cut'

University of Notre Dame associate law school professor Patrick Corrigan told Yahoo Finance that at a minimum regulators have tools to limit payment for order flow. Those regulators include the SEC and Financial Industry Regulatory Authority. However, he described the question of whether the SEC can ban the practice altogether as a legal gray area.

"The authority here is not clear cut," Corrigan said.

Nick Morgan, a former SEC enforcement lawyer, said there’s a reason the SEC, which already requires brokers to disclose payment for order flow arrangements in addition to obtaining best execution for customer orders, has not banned payment for order flow in the many decades the practice has existed.

Commodity Futures Trading Commission Chairman Gary Gensler testifies before a Senate Banking Housing and Urban Affairs Securities, Insurance, and Investment Subcommittee hearing on
Commodity Futures Trading Commission Chairman Gary Gensler testifies before a Senate Banking Housing and Urban Affairs Securities, Insurance, and Investment Subcommittee hearing on "Examining the Causes and Lessons of the May 6 Market Plunge," on Capitol Hill in Washington May 20, 2010. REUTERS/Jim Young (UNITED STATES - Tags: BUSINESS POLITICS)

"The antifraud and disclosure statutes that form the basis of the SEC’s authority don’t support it," Morgan said. "Prohibiting a fully informed customer, who is assured of best execution, from electing to execute free trades through a broker who receives payment for order flow would also go against the surge in democratizing access to securities markets."

One specific regulation that the SEC could use to at least argue for a ban is Regulation Best Interest, Corrigan said. Under the rule, broker-dealers like Robinhood (HOOD) and those with similar services have a duty to provide the best trade execution for their customer orders.

“There's question as to whether this payment for order flow practice creates conflicts of interest in meeting the duty of ‘best execution,’' Corrigan explained. He said representations or omissions about payment for order flow could potentially violate the rule, though the argument isn't a perfect fit for supporting a ban because it applies only when broker-dealers are providing personalized investment advice about securities to retail customers.

"Critically, the SEC couldn't just ban payment for order flow outright under that authority," Corrigan said, unless perhaps it could characterize the platforms as those making investment recommendations.

'Of course it will be challenged in court'

Other avenues that the SEC could tap, Corrigan said, include common law principles that impose fiduciary duties on broker-dealers, as well as agency law principles.

In Gensler's view, payment for order flow indeed presents conflicts of interest between brokerage apps and consumers. “We knew before January that there were inherent conflicts when a brokerage app is maximizing potentially for their revenues, rather than the welfare of their users on the other hand,” Gensler said about January's meme stock trading frenzy that fueled closer scrutiny of payment for order flow.

In a report released earlier in October, the SEC concluded that payment for order flow lures some investors into higher volume trading due to low and no fee trading opportunities. Higher volumes, the agency argued, are typically accompanied by more significant losses for retail investors.

University of Michigan Law School professor Adam Pritchard told Yahoo Finance in July that although the SEC has power to intervene and execute changes to payment for order flow, limitations to the practice are certain to face legal challenges.

“If they decide they want to do a rulemaking with respect to payment for order flow, that’s years before there can actually be a rule,” Pritchard said. “And then, of course it will be challenged in court, and that could drag it on for more years after that” — all of which, he said, could be undone by a subsequent administration.

Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on Twitter @alexiskweed.

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