The Rise of Commission-Free Trading and the Challenge of Robinhood: An Analysis of Payment for Order Flow in American Financial Markets

Abstract

This study is a comprehensive analysis of the payment for order model in American financial markets. It focuses on how the payment for order flow (PFOF) model has progressed with the advancement of financial technology, specifically within the last five years. It examines the factors of how fintech PFOF platforms influence retail trader behaviors and the outcomes affecting American financial markets in relation to progressive capitalism and the rent-seeking theory. PFOF is a controversial revenue producing practice by financial entities pioneered by Bernie Madoff, who ran the largest ponzi scheme in history (Bair, 2021). Should it still be allowed to continue and if not, what effect would banning payment for order flow have on American financial markets and the public? This study examines the background of PFOF in American markets since the late 1980’s and the surge of retail traders on popular fintech platform Robinhood circa 2019. This study provides a chronological review of significant congressional hearings and regulatory agency panels over the last three decades regarding PFOF and an analysis of how platforms like Robinhood influence retail trader behavior and affect financial markets. In 2012, the United Kingdom banned PFOF and data shows retail trading increased as a result. The author of this study concludes that PFOF fintech business models like Robinhood and Webull that depend on the primary revenue generated by this practice, use strategic tactics and design features to encourage retail investors to constantly trade in order to create revenue, regardless of whether it is in the best interest of the user. Therefore, these types of brokers employ aggressive and controversial practices to promote high activity trading that results in high risk trading behaviors. Although PFOF has existed for several decades, the way current PFOF fintech platforms have designed their user experience has led to an increase in popularity among new retail investors. Particularly, among millennials within the last three years. The author concludes the manner in how PFOF platforms like Robinhood and Webull operate, is a system of rent-seeking to attract and exploit retail traders by influencing their trading behavior to create revenue. Critics of PFOF cite best execution practices as a conflict of interest between brokers and their clients. Proponents of PFOF cite that PFOF saves clients money on trading costs versus commissions and adds liquidity to the market. This study concludes lawmakers should ban PFOF immediately and in its entirety to curb the exploitation of retail traders, improve public trust in the American financial markets and increase financial equality in America