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Robinhood falls on SEC's willingness to ban payment for order flow

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Robinhood shares fell on Tuesday after Securities and Exchange Commission Chairman Gary Gensler is open to banning payment for order flow. Yahoo Finance's Brian Cheung shares the details.

Video Transcript

BRIAN SOZZI: Robinhood shares are still under pressure following lightning rod comments from SEC Chairman Gary Gensler. In an interview with Barron's yesterday, Gensler said that a full ban of payment for order flow is, quote, "on the table." Yahoo Finance's Brian Cheung is here with more. Brian.

BRIAN CHEUNG: You mentioned this all coming from a Barron's interview. The head of the Securities and Exchange Commission telling Barron's in an interview that he's not going to rule out the possibility of the SEC cracking down on the practice of payment for order flow. Effectively, what this deals with is the way that brokerages transact the actual orders that come in. Let's say, for example, if you are a trader on Robinhood, or let's say E-Trade, you put in an order, the order will get routed through a market maker like a Citadel Securities or Virtu Financial. Ultimately, it's these market makers that ultimately go to the exchanges to try to execute the trade at the ask price.

Now, what they usually do is they try to find a better price on the market, and then they ultimately divide up the ultimate savings that they would have gotten from getting a better price divided up amongst themselves that they can ultimately finance their own businesses. And then they pay out the rest, which is the payment for order flow, back to the brokerage. The brokerage can then decide if they want to use a certain cut for that for their own operations or then ultimately pass on the cost savings to the consumer in the form of, hey, you asked us finding this stock at, say, $100, we found it for you at $99.995, which means that you get a half of a penny of savings there.

Now, again, payment for order flow, this is a perfectly legal part of the operation for a brokerage. It's a very common thing ever since Robinhood had their zero commission model, which incentivized a lot of other brokerages to follow suit like Charles Schwab, like TD Ameritrade. We saw a lot of consolidation in this space. But obviously, you see the hit to Robinhood specifically because payment for order flow is such a substantial part of their business. And it's also worth mentioning, guys, that the overall aggregate picture for payment for order flow in 2020 because of that lead-up into the meme stock trade-- payment for order flow as a total part of their brokerage revenue-- this is not just Robinhood, but the other major brokerages-- E-Trade, Charles Schwab, TD Ameritrade as well-- it tripled in 2020, which is a big reason why you're probably seeing this weigh on that stock so heavily, guys.

MYLES UDLAND: Now, Brian, this also certainly fits into the holistic picture here of your main area of focus, which is the Federal Reserve. But then you've got Janet Yellen, the Treasury secretary, Gary Gensler. All these folks are interacting. They are all aware of where they're at on which issues they want to view as priorities. And with that progressive group of Democrats coming out yesterday and saying that they would prefer to not see Jay Powell nominated as Fed Chair on the basis of his financial regulation or lack thereof, it does create for an interesting soup here of these issues, some of which are exactly relevant to the Fed, some of which are tangential to the Fed. But it all fits into this shifting picture, I suppose, with general market regulation and the direction of policy.

BRIAN CHEUNG: Yeah, absolutely. And what you're alluding to, I imagine, is the Politico report from yesterday that detailed the letter that was sent by the likes of AOC in addition to Rashida Tlaib and also Ayanna Pressley, perceived to be the more progressive wing of the Democratic Party, to the White House asking them to replace Jay Powell as the head of the Federal Reserve. And this is in line with other commentary that we've seen as well. In fact, even former Federal Deposit Insurance Company Chair Sheila Bair wrote an op ed in Yahoo Finance yesterday saying that she was particularly unhappy with some of the regulatory rollbacks under Chair Powell's lead at the Federal Reserve.

Now, of course, there's a lot of commentary that says actually, a lot of these efforts were driven by Randy Quarles, who's a Trump-era person who was appointed to take on the vice chair of supervision role. But ultimately, a lot of people are arguing the blame does ultimately go all the way to the top, which would be the Fed chair himself. Now, whether or not this moves the needle-- obviously, Biden has not necessarily overall positioned himself as a progressive-progressive Democrat. He's seen as someone who's a little bit more moderate.

And based off of that, that would seem to point to some sort of reappointment of Jay Powell. It's not necessarily the case that he's gotten along with these three progressive people who have written this letter. But of course, on the other side of things, it's not like he's a shoo-in for moderates as well. We've seen concern from the likes of Joe Manchin, a Democrat from West Virginia, who said he's worried about reappointing Jay Powell, but for a different reason. That's because he's concerned about inflationary pressures that he feels are more persistent than the Federal Reserve seems to be telegraphing.

So if you're getting your arms, I guess, twisted in two different directions, maybe that's a good thing. But again, we'll see if that's the way the Biden administration sees it as they continue to sort through the possible renomination or replacement for Jay Powell. Again, his term ends in February of next year, so they have to move on that relatively quickly.

MYLES UDLAND: And I guess, Brian, just to come back to the financial regulation, go back to your prior life covering banking regulation over at S&P. When you think about the conversation that just went down on cryptocurrencies, and then you have what I take to be an offhand commentary on maybe we'll think about payment for order flow-- I mean, it feels like this should be down the list of things that the SEC is looking at, particularly given how prominent a role potential cryptocurrency regulation just played in probably the most important piece of legislation that will go through Washington DC this year.

BRIAN CHEUNG: Yeah, well, when we talk about payment for order flow specifically, I do think it's very interesting that the head of the SEC decided to say outright that it does remain an option or a tool for the SEC to ultimately ban this. Now, of course, there's a lot of legal questions about how they would ultimately do that. And I think that it is interesting for the SEC chairman to actually just say outright that this is an option for us as opposed to dodge the question and say we're still investigating it, which the SEC is. They're trying to take a look. And obviously, there's going to be a lot of reports that are put out there, which could ultimately have policy recommendations for what to do.

But I think at large, it does indeed seem to be a case-- and I'm just kind of posturing here-- for the SEC to ultimately want to crack down on payment for order flow, not necessarily because it's going to uproot the whole industry or try to reinstate commissions or try to X out a middleman in this whole business model here, but simply because of the fact that this could indeed be a bit of a political trap just because of the mechanics of how the SEC would be able to do this. Would this require new legislation from Congress? Does the SEC have the authority to just create some rule that could completely take out this type of business model here?

So I think what is interesting to see, though, is just broadly speaking, the model of payment for order flow apparently isn't as lucrative or as, I guess, attractive for a business to operate. And one big reason is because of the consolidation that we've seen in this space. Take a look, for example, at shares of Morgan Stanley. We know that they finished up their merger with E-Trade not so long ago.

Shares of Morgan Stanley are not trading down like shares of Robinhood are because Morgan Stanley understands that the business model for E-Trade is not necessarily all that profitable as it used to be in the zero-commission world. So I think that this is the type of thing where a lot of people are acknowledging you have to subsidize the business model of zero commission trades somewhere else in the business line. If you're Robinhood and you're relying on most of your revenue on this model, that's a big reason why you're subject to those political headwinds. And we saw that in their S-1.

So I think this is going to be bigger of a business story in terms of how to manage the profitability of this model than it really is a regulatory story. And I think that's why it's really the managers at these companies and the C-suites than it is really necessarily on Gary Gensler himself.

BRIAN SOZZI: The world of stock trading continues to evolve since 1993. Yahoo Finance's Brian Cheung, thanks so much.