Capitol Report: Don't count on a significant SEC assault on the Robinhood enterprise mannequin, specialists say

Securities and Exchange Commission chairman Gary Gensler caught investors' attention this week when he said the ban on order flow payment was an option "on the table" – but experts say MarketWatch is unlikely to that the regulator will take such a drastic step.

In an interview with Barron’s, the SEC chief said that the flow of orders practice – where stockbrokers sell the privilege of fulfilling retail orders in exchange for a profit sharing – creates an "inherent conflict of interest." He pointed out that the UK, Australia and Canada have all banned the practice and that a US ban could also be envisaged.

The news sent stocks of app-based broker Robinhood Markets Inc.
+ 2.84%
down 6.9% on Monday, while that of rival Charles Schwab Corp.
+ 0.79%
fell 3.2%. Although Robinhood stock made up for some of those losses, it is still down more than 4% over the week, according to FactSet. Robinhood generates the majority of its revenue from paying for the flow of orders.

Michael Piwowar, former SEC acting chairman and now executive director of the Milken Institute Center for Financial Markets, told MarketWatch that Gensler's comments are consistent with previous statements on the matter and that SEC policies require periodic reassessment of most regulations.

"I was not surprised that Chairman Gensler said all options are on the table – that is just part of the standard Commission's practice," he said. "In general, the SEC is constantly reviewing all political issues as to whether or not its current set of rules is in line with current market conditions."

Piwowar added that it is especially important that the SEC continuously evaluate market structure issues like paying for order flow because practices and technologies change so rapidly. For example, the advent of commission-free trading platforms is a new phenomenon and it would only make sense for the SEC to reconsider its rules in light of this new reality, he said.

Before the SEC can ban this practice, federal law requires it to hold a long public debate and conduct a comprehensive cost-benefit analysis. Regarding the question of payment for the flow of orders, a rule proposal would have to contain an empirical analysis of all sensible policy options, ranging from the status quo to a complete ban.

After that analysis, the five-person commission could vote on a proposed rule, followed by a month-long public comment period that the SEC must consider before enacting a final rule.

Even if the SEC voted to ban the flow of orders, parties harmed by the decision could sue the agency in federal court if they believe it has exceeded its authority or failed to adequately assess the costs and benefits of the proposal.

"There is a whole regulatory process that can take a year or two to actually move something forward and it would require the other commissioners to weigh things up with the staff," said Piwowar.

It's not clear if the other four SEC commissioners are excited about changing the rules for paying the order flow, let alone banning the practice altogether. Gensler's Democrats on the committee have made public statements suggesting that they believe the issue needs to be investigated. However, the Commission’s two Republicans have stressed that the cost of trading for retail investors has fallen sharply in recent years and that any rule changes should take this into account.

Republican Commissioner Hester Peirce said in February that she believed the order flow payment "likely benefited retail investors as it reduced the cost of closing a deal". She acknowledged that the practice has inherent conflicts of interest, but the solution is to have greater and better disclosure of payments between market makers and brokers.

"A full ban is probably not the most likely outcome here," Ken Joseph, a former SEC enforcement and auditing officer and regulatory advisor at Kroll, told MarketWatch. "I foresee a scenario where increased disclosure is the regime and more emphasis is placed on ensuring brokers meet their best execution obligations to their clients."

Critics of paying for order flow are unlikely to be met with increased disclosure and enforcement of rules requiring brokers to execute trades at the best prices available. After all, the SEC measures the best price by studying the prices that are offered on so-called "lit" exchanges such as the New York Stock Exchange or the Nasdaq. But retail orders are often not executed on these exchanges and these orders are not used to estimate the official best price, the so-called National Best Bid Offer.

"The bigger problem is market segmentation," said Joseph. “Probably only half of the orders are placed in the illuminated markets that provide transparency about what the NBBO is. We only get half the picture. "

Forcing all trading on Lit exchanges, however, would create its own problems and create a system where large institutional traders who manage annuities and 401 (k) s could distort the markets when executing large trades, said he.

Piwowar noted that these are complex problems, always compromised, and that these dynamics give reason to believe that the SEC will refrain from drastic regulatory action. Paying for the order flow creates a conflict of interest, but those conflicts also exist in the commission model because brokers make more money the more trades a client makes, he said.

"The SEC already recognizes this conflict of interest," he said. "Many of the SEC's rules are specifically designed to mitigate this."

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