Will the SEC Take Away 79% of Robinhood's Revenue?

Robinhood could take a big hit if lawmakers ban this revenue source.

Robinhood is one of the more popular brokerage firms, especially among new investors. There are many factors driving its popularity, but one of the biggest is that it was one of the pioneers of commission-free stock trading. The investment app allows you to trade without paying a fee to buy or sell stocks, which means you don't necessarily need a lot of money to start investing since you aren't paying for each transaction.

Many brokers now offer commission-free trades, in large part because of innovative companies such as Robinhood, which made this an option for consumers. Traditionally, investors would have to pay around $7 to $10 for each purchase or sale transaction, which meant frequent trading didn't always make sense -- especially when dealing with small sums of money.

Brokers do have to make money, though. And Robinhood's main source of revenue could be threatened by upcoming regulatory action on the part of the Securities and Exchange Commission. Here's what you need to know.

Could Robinhood lose a crucial revenue source?

Robinhood is at risk of losing one of its most crucial sources of revenue. In the second quarter of 2021, the brokerage firm obtained around 79% of its revenue from something called Payment for Order Flow (PFOF). And it obtained 77% of its money from PFOF in the first quarter of the year.

PFOF occurs when brokerage firms like Robinhood send the buy/sell orders their customers place to specific high-frequency trading firms to execute. In exchange for sending the orders to these firms, brokers receive transaction rebates. These rebates come to brokers from the purchase and sale of all different kinds of investments, including equities, options, and cryptocurrencies.

The SEC, however, is concerned that PFOF transactions cause "an inherent conflict of interest," and the SEC Chairman Gary Gensler has criticized the practice. That's because brokers may route orders placed by retail investors to different firms based on what's in the broker's best interest, rather than based on which offers the best order execution.

Retail investors, in other words, could end up indirectly covering the cost of the fees being paid to the brokerage firm when the broker routes their trades to trading firms based on which firm pays the broker the biggest kickback.

PFOF has existed since at least the 1990s, and brokerage firms are required to disclose their policies and publish details about their relationship with the trading firms they are working with. This includes information about what payments the broker receives. Brokers must also offer quarterly reports on how they route orders.

However, the SEC is concerned that the current regulations aren't strong enough to protect consumers -- especially as an increasing number of brokers are relying on revenue from PFOF to support their business models. The practice also drew renewed attention when Robinhood had to limit trading on certain high-risk securities when investors began snapping up shares of GameStop stock after a group of Redditors organized a short-squeeze.

In light of its concerns, the SEC has said that a full-scale ban of the practice is under consideration. If PFOF is banned, Robinhood would likely have difficulty making up the revenue it loses without fundamentally changing its business model, which involves providing a fee-free experience to retail traders with the goal of democratizing investing.