Intro
Amendments proposed by the SEC would reduce brokers’ payment for order flow (PFOF) revenue and would put some operating models (like that of Robinhood) at risk. Maintaining the zero-commission business model for brokers that rely heavily on PFOF revenue will be an uphill battle.
Technology has significantly changed the US equity market over the past decade and a half. The role of wholesale market makers such as Citadel has become more important, and the proportion of trade executions handled outside of exchanges (also known as off-exchange trades) has surpassed on-exchange executions. Brokers started earning increasingly more revenue from payment for order flow (PFOF). PFOF is a practice where brokers are compensated by market makers for selling customer order flows.
As a result, costs related to retail trading have decreased significantly. However, new issues emerged, such as an uneven playing field between players, lack of transparency, and conflicts of interest. To address these issues, the US Securities and Exchange Commission (SEC) published a proposal in December 2022.
Below, I summarized some of the proposed changes and how these could affect brokers’ PFOF business.
1. SEC proposal: change in order competition and minimum price increment
Currently, brokers route most of their retail orders to wholesalers, such as Citadel or Virtu, rather than to public exchanges / lit market. As Chart 1 shows, there are brokers (i.e. Robinhood or TD Ameritrade), which route client orders solely to off-exchange venues.
Chart 1 - Execution venues % of non-directed orders, average between 2020-2022 Q3
Source: SEC 606 reports
According to the SEC, this trend may hamper competition, as these orders are hidden from other players who can’t compete to provide better prices. Based on the SEC's calculations, the lack of competition costs customers $1.5 billion annually.
To put this into context: I calculated that top wholesalers (Citadel, Virtu, G1X, and Two Sigma) provided combined price improvements of $8.4 billion between 2020 and 2022 Nov. On average, the net price improvement was close to $3 billion per year. Against this backdrop, the SEC’s estimate of annual $1.5 billion in higher costs seems high and difficult to believe.
Chart 2: net price improvement at major wholesalers, 2020 and 2022 November
Source: SEC 605 reports
One of the proposals would require certain orders (e.g. customers making less than 40 trades per day) to be routed into an auction. This auction would be open and transparent, allowing more execution venues to compete and provide better prices.
Currently, the playing field is uneven between on-exchange (public exchanges like the NYSE) and off-exchange (wholesalers like Citadel or Virtu) venues. On-exchange venues can price assets at one-penny increments while off-exchange venues offer sub-penny pricing. The SEC plans to reduce the minimum tick size, which would improve the pricing between on- and off-exchange venues. In addition, the proposal would reduce access fees (the cost of execution on exchanges) and would make them more transparent prior to execution. These changes would boost competition between off-exchange and on-exchange venues.
The expected outcome of these changes would be less revenue for brokers in the PFOF model.
2. Proposed changes would put Robinhood’s business at risk
The changes would significantly affect the business model of brokers, especially the ones that rely heavily on PFOF revenue. In 2021, 77% of Robinhood’s total revenue came from PFOF, while this number was only 11% in the case of Charles Schwab-TD Ameritrade. Fidelity and Vanguard are among brokers that don’t earn PFOF revenue from stock trading (only from options, due to the specific market structure in that segment). Keeping the zero-commission business model for brokers that rely heavily on PFOF revenue will be an uphill battle.
Many US brokers, including household names like Robinhood or TD Ameritrade, provide commission-free trading for US customers and earn their revenue from the PFOF model. TD Ameritrade, Robinhood, and E*TRADE were the ones that earned the most from stock PFOF in the 2020-2022 period (see chart 3).
Chart 3 - US brokers’ stock payment for order flow (PFOF) revenue, 2020-2022 Q3
Source: SEC 606 reports
*Charles Schwab and TD Ameritrade merged in 2021.
The top market makers that are affected are Citadel, Susquehanna, and Virtu. They paid the most for brokers in the form of payment for order flow, as per the chart below.
Chart 4 - Major wholesalers’ PFOF revenue paid, 2020-2022 Q3
Source: SEC 606 reports
Bottom line
It will be a long journey before these proposals are implemented, if at all. However, should the proposed amendments be accepted in their current form, retail brokers earning significant revenue from the PFOF model will be forced to revise their business model. Some may even go as far as reintroducing commissions.
The overall ambition of the SEC to make markets more transparent and competitive is laudable. Nevertheless, radical changes may backfire and result in less efficiency along with higher costs. A generous timeframe dedicated to consultations with market participants and affected parties as well as impact calculations and tests would be crucial prior to implementation.
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