The ‘meme stock’ craze led to wild fluctuations in stocks like GameStop and AMC prompted calls from some progressive lawmakers to institute new “government-knows-best” regulations. Democratic lawmakers have proposed curtailing certain practices, like banning payment for order flow (PFOF), enhanced filing requirements on short selling, or even imposing a new tax on stock trading. Even Securities and Exchange Commission (SEC) Chairman Gary Gensler recently said banning payment for order flow is “on the table.” While some have been quick to disparage PFOF, lawmakers should acknowledge its pro-consumer benefits that have allowed the near ubiquitous service of commission-free investing apps. PFOF allows more retail investors to save for their future and participate in the stock market and its prohibition should not be on the table by lawmakers or regulators.
Investing in the stock market can be a daunting task, and with less direct access to brokers and high fees for investing, retail investors historically faced significant barriers to entry. The costs associated with investing have dropped, paving the way for more investors to get involved in the stock market. Similarly, advances in technology allow retail investors to invest with relative ease. In 1985, roughly twenty percent of the Americans invested in the market, compared to fifty-six percent of Americans today. This near tripling of American investors is a positive development that should be celebrated. While several factors likely contributed to the increase in participation, lowering costs and barriers to entry played a major role in expanding the market to more retail investors.
A major reason for the growth in individual investing has come from the rise of online and app-based trading platforms, such as Robinhood. Robinhood has grown to over 20 million users in 2021 and is now generally at the center of PFOF debate. Robinhood, like any other business, must be profitable to continue to provide services for consumers. Rather than charge a commission fee to its users, Robinhood utilizes PFOF to provide a valuable service. PFOF expands investment opportunities to retail investors who may be unable or unwilling to pay commission fees or meet minimum account requirements.
PFOF has been at the center of much of the debate. As an example, here is how PFOF can work:
- An investor decides to buy a stock;
- The brokerage sends the trade to a wholesaler or market maker;
- The market maker can match a buyer and seller or buy/sell the share themselves;
- The market maker makes a profit on the bid-ask spread and shares part of the profit with the brokerage. From there, the brokerage can pocket the profit and/or pass on the savings to the investor as a price improvement.
This practice essentially allows for the prevalence of commission-free stock trading, but it has been subject to criticism, including that it gives rise to a conflict of interest. To some, the brokerage may be incentivized to boost their bottom line and not find the best execution price. PFOF is subject to the duty of best execution and disclosure requirements. As an SEC report notes, the issues arising from PFOF are difficult to distinguish from those that arise when an integrated broker-dealer, with a retail customer business and a market-making desk, internalizes its own customer order flow. Another criticism of PFOF is that it encourages brokerages to push customers to trade more often, even if it is not in their best interest.
These concerns notwithstanding, consumers should have the ability to choose whether they want to invest in commission-free trading services that use PFOF, or services that are commission-based. The choice to invest should be left to the investor. It may be true that retail investors are less informed than other professional traders, but raising barriers to retail investors would not create more informed investors. Some investors may choose riskier investments, while others opt for safer trades. However, investing should not just be reserved solely for the wealthy.
Thankfully, Senator Pat Toomey (R-PA), Ranking Member on the Senate Banking Committee, has been a vocal proponent of ensuring retail investors maintain access to commission-free investing and recently introduced legislation, the Investor Freedom Act of 2021, that would restrict the SEC from prohibiting PFOF. The SEC Chairman’s openness to banning PFOF is problematic for retail investors and would raise barriers to investing. If PFOF were banned, brokerages would likely impose commission fees on investors to sustain their operations. Making investing harder, more expensive, or less user friendly is not in the best interest of retail investors. Senator Toomey’s legislation would preserve commission-free trading and access to investing for millions of Americans.
“Never let a crisis go to waste” is a common theme in Washington. The widespread adoption of commission-free trading has allowed consumers from all backgrounds and income groups to grow their wealth and save. The newsworthy bits of “meme stocks” dominate the discussion, but it is important to remember that retail investors are able to choose 401(k)s, mutual funds, or other safer options, too. Ultimately, the decision to invest should be left to the consumer, and while lawmakers may have valid concerns about young people investing, lowering barriers to entry is a positive development made possible in part by commission-free trading. Banning PFOF could undo this progress and make it more difficult for retail investors to participate in the stock market. Lawmakers should stand on the side of consumers, retail investors, and taxpayers by passing this important legislation.