Gambling has always been an element driving investor behaviour in the stock market.
The highly speculative growth of equity prices since 2008 highlights that some investors — large and small — treat the stock market as something akin to a slot machine. Yet, the developments of nascent brokerage platforms — most notably Robinhood — is an even further development in the gamification of the financial sector. These dynamics have caught the interest of the US Securities and Exchange Commission, which is threatening to clamp down on financial gamification and the ‘order flows’ that present a troubling conflict of interest. This move by SEC Chair Gary Gensler is part of a broader attempt to make the $45tn equity market more transparent. And Gensler’s objections to order flows stem from two issues.
First, there are the inherent conflicts of interests in an order flow derived profit model. Payments-for-order flows have been around since at least the 1980s and proponents argue that they have allowed platforms to reduce trading costs, which creates more opportunity for retail investors. Yet they have also produced the emergence of the brokerage models used by Robinhood, where the company receives greater revenue as the volume of trades that they sell to other firms, such as Citadel Securities, grows. In total, Robinhood generated $682m in payments-for-order-flow revenue in 2020 and selling order flows make up the majority of the company’s revenue.
The problem? Along with the order flows, purchasing companies also acquire useful data on the investment behaviour of the people — typically young people investing a few thousand dollars — that use applications like Robinhood. Often these secondary brokers ‘take the other side’ of these users and attach commission charges. This explains the huge premium these brokers pay to process Robinhood trades. And it is why Gary Gensler described order flows as presenting ‘an inherent conflict of interest’.
Recently, the SEC fined Robinhood $65m for misleading customers about its revenue sources and, more importantly, failing to complete trades at fair prices. The SEC estimated that poor Robinhood trading prices cost users over $34m in lost capital gains. As Gary Gensler commented, secondary brokers ‘get the data, they get the first look, they get to match off buyers and sellers out of that order flow.’
Second is the incentive to gamify stock trading to increase trade volumes. Since companies like Robinhood generate revenue by selling order flows to external firms, the SEC worries there is a clear incentive to encourage users to keep trading stocks. This incentive partly explains the emphasis Robinhood has placed on creating an engaging user experience — digital confetti after trades, fire emojis and lottery-style finger swiping all make the Robinhood investor experience fun and addictive.
Moreover, limited available market data and sensible investment advice create few guardrails to prevent novice investors from making foolish decisions. Given the small barriers to receiving level three options authorisation which opens up spread trading, the capacity for novice investors to take on incredibly high leverage and risk is elevated. These dynamics are good for Robinhood and good for the secondary brokers that they sell order flows to, but they are often terrible for the largely inexperienced and young investors that use the platform.
The combination of misaligned incentives and scandalous abuse of user investment data by larger financial firms is why the SEC is right to go after order flows. In June, the SEC indicated it is prepared to consider a complete ban on selling order flows — this announcement unsurprisingly preceded a large tumble in Robinhood’s share price. If Gensler moves forward with restrictions on order flows, it would be welcomed move in curtailing a particularly perverse incentive structure that is simultaneously encouraging speculation and also rigging the financial system further against small, young and novice investors. Above all, the case of Robinhood and order flows presents a cautionary tale for the future: in a digital economy, increased access does not always indicate increased fairness.
Julian Jacobs is Economist at OMFIF.