It's been a tough year for markets, with the S&P 500 firmly in bear market territory. Young, unprofitable companies, like Robinhood (HOOD 3.60%), have been hit the hardest by the selling. Since peaking shortly after its initial public offering in August, the stock has dropped about 80%. One cloud hanging over Robinhood was the risk of new regulations that could cut off its primary source of revenue.
Regulators recently ruled that they would not ban payment for order flow, a practice central to Robinhood's business. The brokerage stock popped on the good news, but the company isn't out of the woods.
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NASDAQ: HOOD
Key Data Points
Payment for order flow has come under scrutiny following the meme-stock frenzy
Last year, news came out that Securities and Exchange Commission Chair Gary Gensler was considering a ban on payment for order flow. The practice came under scrutiny last year following the GameStop stock surge, where retail investors drove up the share price by 1,600% over a few weeks.
Payment for order flow is a crucial piece of Robinhood's business, and is why the broker can offer commission-free trading. It works like this: A broker like Robinhood sends its flow of buy and sell orders to a market-making firm. This market maker collects the difference between what a buyer agrees to pay and the price a seller agrees to accept (also known as the bid-ask spread). The market maker then returns a portion of this spread as payment for receiving order flow from the broker.
Some have argued that selling order flow creates a conflict of interest for brokers, who could focus on maximizing profits rather than delivering the best available prices to their customers
Most of Robinhood's revenue comes from selling order flow
Investors breathed a sigh of relief when the SEC announced that it would not ban payment for order flow, following months of deliberation. That's because 79% of Robinhood's revenue comes from routing users' trade orders to market makers.
Dan Gallagher, Robinhood's chief legal officer, was not surprised, saying, "We have consistently expressed our confidence that the SEC, after careful consideration, would not pursue a payment for order flow ban." Gallagher told Barron's last year that "payment for order flow is an amazingly good thing for investors," and the company has argued that payment for order flow is the driving force behind falling trading commissions over the last two decades.
Last year, Gensler told CNBC that "our markets have moved to zero commission, but it doesn't mean it's free. There's still payment underneath these applications. And it doesn't mean it's always best execution."
A ban is off the table, but other regulations are likely
It was unlikely that the SEC would impose a blanket ban on payment for order flow. After all, companies like Charles Schwab, Morgan Stanley, Fidelity, and Ally Financial also rely on the practice to generate revenue.
But this isn't the end of the story. Regulators are still looking at ways to improve market structure. In September, Gensler told Congress that he "believes that it's appropriate to look at ways to freshen up the SEC's rules...to make our equity markets as fair, efficient, and competitive as possible for investors, particularly for retail investors."
The SEC is considering other actions, including lowering access fees that exchanges charge brokerages, which could put more trading onto the exchanges and away from market makers. It could also change the rebate system exchange operators use to entice trading volume and force brokers to disclose to their customers how much it costs to trade with them compared with benchmarks.
While the commission hasn't made a final decision regarding these potential changes, experts say that any changes could make payment for order flow less profitable. For Robinhood, this means that its primary source of revenue could still come under pressure.
