The American Prospect is a nonprofit, independent magazine covering public policy and politics. Sludge is re-publishing this article.
Few arcane financial transactions have attracted more widespread attention than payment for order flow, the stock and securities trading system in which a brokerage firm sells the market orders of its users to different market makers (such as Citadel Securities) for execution. In turn, the brokerage firm receives a small payment, usually a fraction of a penny per share, as compensation for directing the order to one third-party executor over another. It’s the signature process of trading apps like Robinhood, Charles Schwab, E-Trade, and others.
Critics—among them the Securities and Exchange Commission—say those payments cause a conflict of interest, and screw traders, who aren’t guaranteed the best possible price for their purchases. The process also incentivizes the apps to push investors to make more trades, which will generate more fees. Of course, it’s typically the case that the more retail traders trade, the more they lose.
Given Wall Street’s incredible creativity in the time-honored tradition of ripping people off, it’s pretty small-bore, the equivalent of robbing the “Give a penny, take a penny” tray. But if you do that repeatedly, it adds up, and so too has payment for order flow, becoming hugely profitable for online brokerage firms like Robinhood, E-Trade, and Charles Schwab, all of whom now offer “commission free” trading.
According to Schwab’s most recent annual report, “trading revenue,” which includes order flow, represented 12 percent of its entire net revenue in 2020, nearly double the year prior. Schwab made $621 million in 2020 from order flow, and has already made over $1.5 billion from the practice in the first three quarters of 2021 alone. Robinhood, meanwhile, gets about 80 percent of its revenue from payment for order flow.
While Redditors and regulators alike have expressed outrage over the seemingly conflicted profiteering that order flow has created, online brokerages claim that it’s the only way to open market trading to everyone. And they have found themselves a defender: Republican Sen. Pat Toomey.
In October of this year, Toomey introduced the Investor Freedom Act of 2021, which would prevent the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and national securities regulators from “issuing any rules that prohibit” payment for order flow. In essence, the bill protects the sanctity of Wall Street firms’ storied tradition of taking advantage of unsuspecting customers.
That bill came not long after SEC chairman Gary Gensler said the commission was looking to significantly reform the practice because of those abuses. It’s not the first time Gensler has threatened that: In August, he said an outright ban of order flow was “on the table.”
Robinhood has pushed back on scrutiny of the practice, claiming that there is “no evidence” that payment for order flow takes advantage of investors. They have denied, too, that the practice contributed to the major controversies the company has been involved in, like when Robinhood users were restricted from buying meme stocks on January 28.
Toomey, echoing the talking points of the online trading firms, also claims the current system is actually a boon to small traders. “New innovations—such as zero commission trading and user-friendly mobile apps—have allowed more Americans to participate in the stock market than ever before,” Toomey said in a press release. “Such technologies have been made possible in part by payment for order flow.”
It will come as little surprise that Toomey, the ranking member of the Senate Banking Committee, has jumped into the fray to defend the extortive practices of brokerage firms. Trading houses, market makers, and their executives have contributed over $200,000 to his campaign coffers over the years. Among them, he’s banked $21,000 from Morgan Stanley, owner of commission-free brokerage E-Trade, $16,000 from Charles Schwab, and $18,500 from the Securities Industry and Financial Markets Association (SIFMA), a financial services lobbying group.
He’s even gotten at least $17,800 from billionaire Ken Griffin, the founder and CEO of Citadel, the reviled fund at the heart of the GameStop scandal. Citadel, the market maker that works closely with Robinhood, handles 37 percent of all U.S.-listed retail volume. Other market makers, including Susquehanna and the Chicago Board Options Exchange, have donated to Toomey as well.
“Pat Toomey has been in the pocket of Wall Street his entire career, usually at the expense of Main Street. So it’s no surprise Toomey is attempting to fend off any regulation of a risky practice that leaves everyday traders vulnerable to conflicts of interest and exploitation at the hands of unaccountable third parties used by brokerage firms,” said Accountable.US president Kyle Herrig in a statement.
Order flow is not required for free trading, nor is it needed for online brokerages to make money. Other countries’ financial and securities sectors manage to offer commission-free trading without payment for order flow. eToro, one retail brokerage, operates out of Israel, where order flow is illegal.
Toomey’s difference of opinion with the SEC and the entirety of the WallStreetBets subreddit is substantial. “My question to the SEC is, exactly what is the harm that’s being done here? Who’s being harmed?” he asked in an interview with Yahoo Finance in November.
Toomey announced last year that he would not be seeking re-election in 2022, at the end of his current term. His lame-duck status has allowed him to more enthusiastically defend the Wall Street firms that have boosted him during his 12 years in office. As a former Wall Street banker himself, and the erstwhile president of the conservative dark-money group Club for Growth, Sen. Toomey and those firms are no strangers.