Why this Republican senator wants to protect a controversial trading practice

Payment for order flow has helped companies like Robinhood (HOOD) change the world of retail investing. But this technical trading maneuver has become a problem for many in Washington: Congressional hearings have targeted the practice, as some have characterized it as a kickback for brokerages. Meanwhile, the SEC has said a ban of payment for order flow is very much “on the table.” 

But one lawmaker wants to move in the opposite direction and stop action before it begins. Sen. Pat Toomey (R., Pa.), ranking member on the Senate Banking Committee, recently introduced a bill to "preserve commission-free trading" and prohibit the SEC from banning the practice.

“My question to the SEC is, exactly what is the harm that's being done here? Who's being harmed?” Toomey said in an interview with Yahoo Finance. “It's not clear to me that there's any greater conflict of interest with payment for order flow than there is in any other arrangement between a broker and a customer.”

The Yahoo Finance Presents conversation also touched on issues like how best to regulate stablecoins and what he sees as "badly flawed" cryptocurrency provisions in the infrastructure bill.

'Inherent conflicts of payment for order flow’

The practice of payment for order flow allows for zero-commission trades because online brokerages like Robinhood and E*trade can make money by routing the orders from investors that come in to wholesale market-makers like Citadel Securities and Virtu Financial. These market-makers pay the brokerage company a fee and then make money by executing the trades at a better price than the original customer asked for and pocket the difference.

The concern is that many investors aren’t getting the best deal they could and losing out under the guise of “free” trades. Brokers are legally required to seek the best trade execution for their customers and the concern is this creates a conflict of interest between the best deal for a broker’s customers and a market-maker offering a fee.

Robinhood itself has pushed back on the scrutiny of the practice, saying there is "no evidence" that payment for order flow takes advantage of investors or contributed to events like when Robinhood users were restricted from buying meme stocks on Jan. 28. The company recently argued “the overwhelming evidence is that the current market structure works well for retail investors.”

But SEC Chair Gary Gensler recently discussed “the inherent conflicts of payment for order flow” in an interview with Yahoo Finance and said restrictions or even an outright ban remain a possibility.

A recent SEC report looked critically at a range of investing business practices, including the "gamification" of investing and payment for order flow and how they could lead to increased trading volume. The agency, however, offered no specific policy recommendations.

‘The SEC has not made the case’

For Toomey, the increased volume is good and part of the point. “Tens of millions of Americans are investors who never were before, and they are therefore participating in the returns of the greatest capital market on the planet,” he said. Payment for order flow is “not the whole reason, but it's a contributing factor,” he added.

He also pointed out that any investor who doesn’t want their trade to go through the payment for order flow process has options. They can use brokerage firms that offer alternatives and simply pay a commission.

“The SEC has not made the case for why there's something broken here,” Toomey said.

The prospects for Toomey’s bill, the Investor Freedom Act of 2021, are uncertain in the week since he introduced it.

Ben Werschkul is a writer and producer for Yahoo Finance in Washington, DC.

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