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Congressional Democrats called on regulators to enact stricter oversight of commission-free trading apps in interviews with MarketWatch, in the wake of online brokerage Robinhood’s $65 million settlement with the Securities and Exchange Commission for misleading customers about how it makes money from customer’s trades.
The SEC said that between 2015 and 2018, Robinhood made misleading statements about its practice of earning money by routing some customer orders to trading firms at inferior prices, a practice called payment for order flow that the SEC said cost customers $34 million relative to other firms that charged $5 per-trade commissions.
“Robinhood is supposed to steal from the rich and give to the poor, and instead it appears it is stealing from the poor investors and giving to [Robinhood founders] Mr. Bhatt and Mr. Tenev,” Brad Sherman, chairman of the House Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, told MarketWatch in an interview.
Robinhood settled the charges without admitting or denying the SEC’s findings, and the firm says that it is fully transparent with customers about its current revenue streams.
“The settlement relates to historical practices that do not reflect Robinhood today,” Dan Gallagher, chief legal officer at Robinhood said in an email. “We recognize the responsibility that comes with having helped millions of investors make their first investments, and we’re committed to continuing to evolve Robinhood as we grow to meet our customers’ needs.”
Furthermore, though Robinhood pioneered the no-commission trading model, competitors including Charles Schwab Corp. SCHW, +0.39% , E-Trade and TD Ameritrade have copied it, and have long earned revenue through payment for order flow even when they were charging commissions.
“Robinhood was the first of it’s kind. Its business model was unique in that their margins on payment for order were so much higher” than their competitors, said Amy Lynch, a former SEC regulator and president of FrontLine Compliance.
“But Robinhood’s competitors have followed suit and the SEC may well be looking at their payments for order flow now that there are no commission charges at most online brokerages,” she added.
The practice has long been controversial. In 2014 then Sen. Carl Levin, a Democrat from Michigan, called on the SEC to outlaw payment for order flow entirely. Supporters of the practice, however, say that it has coincided with a trend of lower fees, greater convenience for average investors and generally lower bid-ask spreads on financial instruments that make it less costly to invest.
Under outgoing SEC Chair Jay Clayton, the regulator attempted to set up a pilot program that would test whether rebates and fees for orders at major financial exchanges like the New York Stock Exchange NDAQ, +0.08% and Nasdaq lead to worse execution for investors, but federal courts ruled the effort unlawful.
“We’ve got to look at whether payment for order flow is consistent with protecting investors,” Sherman, a California Democrat said. “The SEC needs to come to us more often with legislative proposals to give them the tools they need.”
Rep. Sean Casten, a Democrat from Illinois and fellow member of the investor protection subcommittee said in an interview that he is concerned the $65 million settlement is not a strong enough penalty to deter the industry from shortchanging their customers.
He pointed to the $180 million in revenue Robinhood said it earned from payment for order flow in the second quarter of this year as evidence that “the gain they have realized from this behavior has exceeded the penalty.”
Casten also raised concerns over the structure of Robinhood’s app, which critics say has features that encourage frequent use of the app, which observers have labeled gamification. “To my mind gamification is antithetical to investor protection,” he said, adding that the industry should be instead creating incentives for average investors to make fewer trades and instead invest for the long term.
He added that initial conversations he’s had with the Financial Industry Regulatory Authority, the brokerage industry’s self-regulatory body that’s overseen by the SEC, suggest that they take the issue of gamification seriously.
“I’m pleased the SEC has taken this first step,” Casten said. “I just don’t think that it’s the end of the process.”
