Every so often, the Securities and Exchange Commission (SEC) will introduce new rules to protect investors and ensure the fair, orderly operation of markets. The SEC recently proposed rules taking aim at the practice of payment for order flow (PFOF), which is when brokers sell their order flow to market-making firms.
These rules would impact brokerages like Robinhood (HOOD) that rely on PFOF revenue. One company feeling the most significant effects will likely be the market-making firm Virtu Financial (VIRT 0.44%).
Last year the SEC declared that it wouldn't ban PFOF but instead would pursue disclosures and other methods to ensure customers get the best prices on their orders. These reforms could considerably impact Virtu's business and its high dividend yield. Here's what you need to know about the proposed changes and what happens from here.
The SEC is proposing these changes to ensure customers get the best prices possible
The SEC occasionally tweaks its rules to protect investors and maintain fair, orderly, and efficient markets. The practice of paying for order flow has been around for decades but has come under intense scrutiny from regulators in the last few years.
PFOF occurs when retail brokers, such as Robinhood, send customer orders to wholesale brokers, not exchanges, to execute orders. Retail brokers accept payments from wholesalers in return for customer orders. The SEC is concerned that the practice creates an incentive for retail brokers to route orders to specific wholesalers, or market makers like Virtu, to maximize their own revenue instead of getting customers the best price.
One of the driving forces behind this scrutiny is Robinhood's heavy usage of PFOF. Approximately 79% of Robinhood's revenue comes from routing its users' trade orders to market makers. In December 2020, the SEC fined Robinhood $65 million for providing "misleading information to customers about the true costs of choosing to trade with the firm" and failing "to obtain the best reasonably available terms."
The SEC stopped short of banning the practice but recently proposed rules that ruffled the feathers of Virtu and Robinhood. Two rules specifically have come into focus. The first would call for increased disclosure from brokers receiving PFOF, requiring them to show how they obtained the best execution for trades. The second rule would require orders to be auctioned off for best execution in public marketplaces before being executed by a market maker. The SEC estimates that such regulations could save retail investors $1.5 billion annually.
New rules could hurt Virtu Financial and its high-yielding dividend
Virtu and Robinhood oppose these new rules, which would be the most significant securities change in over a decade. The companies argue that PFOF is why trading commissions have dropped in the last two decades and is why Robinhood has been able to offer commission-free trading.
In an interview with Bloomberg's Larry Tabb in February 2021, Virtu CEO Doug Cifu defended the practice, saying investors saw a $3.7 billion price improvement as a result of PFOF while brokers made $1.3 million from selling this order flow (based on data from SEC company reports and Bloomberg Intelligence data).
The rule about routing orders to auctions and then directing them to market makers will hurt Virtu's bottom line. This could result in a revaluation of the company's stock and a potential dividend cut, which currently yields investors 4.69%.
This situation with Virtu serves as a good reminder to investors that it's important to understand regulations or other factors that could threaten a company's long-term growth -- and potentially hurt future dividend payments.
What happens from here
To adopt new rules, the SEC starts with a concept release, then a proposal, followed by a public comment period, then it will meet up and vote on adopting new rules. The current rules relating to PFOF are going through their public comment period, which will remain open until March 31, 2023.
Virtu will fight the SEC tooth and nail against the changes and has already brought a Freedom of Information Act lawsuit against the agency. Regarding the case, Cifu said:
We do not take lightly the step of suing our primary regulator, but it has become clear that the Chair of the SEC is more focused on politics and regulation by innuendo and hypothesis than earnestly engaging with an industry that has created the most fair and competitive equity markets for retail investors globally.
It will be interesting to see where things go from here. If the rules are adopted, Virtu's business will likely take a big hit, and its dividend payout will suffer too. Given the uncertainty around these new rules, I'll be avoiding the stock for now.
