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E-MailJ.W. Verret is Associate Professor at George Mason University Antonin Scalia Law School and Managing Director of Veritas Financial Analytics LLC. This post is based on his recent paper.
This paper considers a rulemaking effort underway at the Securities and Exchange Commission to regulate the conflicts of interest that result when brokers send client orders to venues that pay the broker a fee in exchange for routing to them. These payments for order flow or rebates present a distortive conflict to a broker’s duty of best execution that has troubled the SEC for over 40 years and which the SEC has tried to regulate through multiple reforms. Courts have described the broker’s duties to their client as having a fiduciary character, which has long led some to question whether PFOF and exchange rebates violate that duty. The SEC’s new Chair has indicated he will more forcefully address broker conflicts. He has even suggested that an outright ban on PFOF and exchange rebates is “on the table”. Robinhood, a popular trading app that makes most of its equity trading revenue via payment for order flow, has threatened to challenge the rule in court.
Analysis of this rule, and of the likely outcome in subsequent court challenge, shows that Robinhood is likely to lose. The four top broker recipients of payment for order flow obtained $2.5 billion in PFOF in 2020, thus they have much at stake in this reform. The three dominant stock exchange families (particularly NYSE and NASDAQ) also have a stake in this rule, given that it is likely to prohibit similar broker inducements paid by stock exchanges. Supporters of the current system argue that zero commissions, popular among retail investors, are at risk if PFOF and exchange rebates are banned. While that may be true for some business models, this article notes that it is not true for business models like Fidelity that manage to provide zero commissions without accepting PFOF. This pending rule may well be the most substantial of Chair Gensler’s term and stands to bring more significant reform to the national market system than anything since the 1975 amendments to the Exchange Act that established the national market system. Yet this analysis is of interest not merely to brokers accepting PFOF and to the wholesale brokers and stock exchanges that pay them. This challenge also offers a deeper appreciation of the administrative law environment of SEC rulemaking in the market structure context.
Along the way the reader is taken on a tour of lesser-known SEC rulemaking objectives that take on surprising significance in the market structure context. The paper offers a sharp contrast between the strict judicial review the SEC has seen in corporate finance and corporate governance rules against the more deferential review the SEC is likely to experience in market structure regulation. This paper provides a checklist that the SEC will need to consider to ensure that the rule survives, including analysis that will need to be included in the final rule and questions that will need to be asked in the initial proposed rule.
The SEC’s competition objective will play a central role in this rule, reminding readers that the SEC is, at least to some extent, an antitrust regulator. This may prove one of the first rules in which the SEC stretches its economic analysis and regulatory prowess to borrow tools from analogous antitrust regulation used by the FTC and the banking regulators.
The SEC’s statutorily required fairness objective will also feature prominently in this rule. This fairness focus does not easily lend itself to economic analysis and therefore will require that a qualitative conflicts analysis be paired alongside any traditional economic analysis. Since prior SEC rule challenges have focused on economic analysis, it would appear a rulemaking effort under the fairness objective bolster’s the SEC’s chances of success.
The paper also considers the relevance of traditional economic analysis and offers a survey of some of the existing economic literature casting doubt on whether broker inducements are truly benefiting retail investors in the aggregate. This debate in the literature continues in the final hours before the proposed rule, in the last several weeks Robinhood sponsored research available here arguing that PFOF is associated with optimized execution. The work was criticized by reform advocates as over-relying on the flawed and manipulable National Bid and Best Offer (NBBO) as a metric for execution quality. Another last-minute paper that should slip into the SEC’s economic analysis file for the proposed rule was developed by Public, a broker-dealer who switched their business model from accepting PFOF to commit to no longer accept it. Public used that event as a natural experiment in a piece available here. Through comparing execution quality before and after the decision to stop accepting PFOF, Public was able to show that PFOF was associated with reduced retail execution quality.
It may be tempting for followers of the SEC’s transaction fee pilot, which was struck down by the DC Circuit, to anticipate that this precedent will mean that a legal challenge to more forceful SEC rulemaking in the market structure context will be more likely to succeed. This paper analyzes that prior challenge to show that the SEC lost because they did not adopt a forceful rule and appropriately defend it with sufficient economic analysis and sufficient fairness analysis. What begins as an analysis of a specific rule in this paper, and a brewing challenge between Robinhood and the SEC, ultimately provides a richer understanding of the SEC’s multi-factor mission and of the administrative law constraints governing SEC rulemaking in the market structure context.
The full paper is available for download here.
