SEC says brokers lured by order flow payment are trading a game to lure investors

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The Securities and Exchange Commission says online brokers, incentivized to boost revenue through the industry’s controversial pay-for-order-flow practice, are turning stock trading into a game to encourage activity retail investors.

Wall Street’s top regulator released its highly anticipated report on the GameStop mania earlier this year on Monday. The 44-page report details how the trading frenzy has subsided and raised red flags on a number of issues, including the back-end payments brokerages receive, the gamification of trading, as well as the short selling disclosures. But it stopped short of blaming a single cause or entity.

“Payment for order flow and the incentives it creates may lead brokers to find new ways to increase engagement with clients, including using digital engagement practices,” said officials of the SEC in the report.

Order flow payment is one of the main sources of revenue for Robinhood, the millennials’ favorite stock trading app that has attracted a record number of new customers over the past year and gone public in August. The practice, however, is coming under increased scrutiny as many say it has a conflict of interest with brokerages incentivized to send orders to the market maker who pays them the biggest rebate. SEC Chairman Gary Gensler had warned that banning the practice was not out of order.

To motivate trading, some brokers, including Robinhood, have made their platforms visually appealing and offer game-like features such as points, rewards, leaderboards, and bonuses to increase engagement. Amid criticism, Robinhood got rid of its confetti animation in March.

“It is worth asking whether game-like features and celebratory animations that are likely to create positive investor feedback encourage investors to trade more than they otherwise would,” the report states.

Still, the SEC’s review may not be enough for some in terms of concrete recommendations and laying the groundwork for potential changes to US business practices. The agency also did not come to a conclusion about whether any of the exchanges – and the restrictions on trading – were manipulative and whether the brokerages played by the rules during the mania.

The agency acknowledges that the extreme volatility in meme stocks has tested the capacity and resilience of markets.

Risk management and transparency

At the height of the mania in January, a group of amateur traders on Reddit’s WallStreetBets forum bet on heavily sold stocks “over the moon”, creating huge short squeezes on names like GameStop and AMC. The unprecedented volatility backfired on Robinhood, which had to tap lines of credit and restrict trading on a list of short-term names, as Wall Street’s central clearinghouse at one point imposed a multiplication by ten of the company’s filing requirements.

“This episode highlights the critical role that compensation plays in managing risk for stock trading, but raises questions about the possible effects of sharp margin calls on smaller capitalization brokers and on other companies. other ways to reduce their risk,” the SEC report said. “One method of mitigating the systemic risk posed by these entities to the clearinghouse and other participants is to shorten the settlement cycle.”

The SEC also questioned whether greater transparency of short selling should be required. Currently, securities lending and borrowing is a relatively opaque system, as investors are not required to declare their bearish bets and the SEC only collects data on how much a company has in stock. sold short.

“The interplay between short selling and price dynamics is more complex than these narratives suggest,” SEC officials said in the report. “Improved reporting of short sales would allow regulators to better track this dynamic.”

Gensler will be on CNBC’s Squawk on the Street at 9:35 a.m. ET on Tuesday to discuss the report’s findings.

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