Brokers’ Compensation Revenues Disadvantage Retail Investors

March 10, 2021 by Victoria Turner
FILE - In this Jan. 28, 2021, file photo, pedestrians pass a GameStop store on 14th Street at Union Square, in the Manhattan borough of New York. The recent GameStop frenzy provided what parents and educators call a teachable moment - an opportunity that presents itself to lend a little insight. The Associated Press talked to a few parents and financial experts for their tips, and included in their advice was teaching kids early on about money, keeping the discussions simple but interesting and letting kids practice investing. (AP Photo/John Minchillo, File)

WASHINGTON – A conflict of interest built into online broker Robinhood’s revenue came under scrutiny during Tuesday’s U.S. Senate hearing on retail investing. Three witnesses at the hearing called for a ban on brokerage firms being compensated for routing their clients’ trades to third parties for execution.

Brokers profit more from these “order flow” agreements than from service to retail investors; in Robinhood’s case, the average working American, said Gina-Gail Fletcher, professor of law at Duke University. 

Her remarks came as she testified before the Committee on Banking, Housing and Urban Affairs’ hearing entitled, “Who Wins on Wall Street? GameStop, Robinhood, and the State of Retail Investing.”

“It undermines the relationship between the broker and the client because it pits the revenue source against [the retail investor],” she added. These agreements are known as “payment for order flow.” 

Payment for order flow arises when brokers like Robinhood send their clients’ trade requests for execution to wholesalers like Citadel, who then pays Robinhood a fee for referring the orders. Last month, during a House hearing looking into January’s market volatility from feverish trading of GameStop by retail investors, CEO Vlad Telev testified that over 50% of Robinhood’s revenue came from this type of arrangement. Telev, however, said this model allowed them to offer the everyday investor zero-commission trading. 

Nevertheless, Fletcher said, the practice incentivizes brokers to “put their own profit-seeking interest” before those of the retail investors they serve. Instead of ensuring the best trading price for their client’s order, brokers will be inclined to go with the wholesaler offering the highest fee.

The retail investor, she said, has little information on price movements. According to Fletcher, in countries banning this model like the U.K., this prohibition has resulted in a better price for retail investors.

“If you don’t see what you’re paying for, you’re probably paying more than you would be comfortable with,” agreed Rachel Robasciotti, founder and CEO of Adasina Social Capital. 

On the other hand, Michael Piwowar, executive director at the Milken Institute and former acting commissioner at the Securities and Exchange Commission, warned that calling for an outright ban could backfire.

The ban would just “shift” the conflict of interest instead of fixing it, he said. It would eliminate zero-commission trading and return brokers to commission-based trading. The risk here then becomes brokers excessively trading their client’s portfolio in order to charge them more commissions, he explained.

January’s short-sale “frenzy,” during which a number of retail investors borrowed overvalued stock like GameStop to sell at market price and later bought it back at a lower price before returning it to the broker, pocketing the difference. This unprecedented move by retail investors caused stock prices to soar, drop and rise again, leading to both losses and gains by those participating. It prompted the first Congressional hearing on the matter by the House Committee on Financial Services in February, with the second hearing slated for next week. 

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