EXPLAINER-Robinhood makes most of its money from PFOF. What is it?

By John McCrank

NEW YORK, July 29 (Reuters) - App-based retail brokerage Robinhood Markets Inc was set to make its highly anticipated market debut on the Nasdaq on Thursday.

The brokerage, known for helping pioneer commission-free trading, relied on a controversial practice called payment for order flow (PFOF) for more than three-quarters of its revenue https://www.sec.gov/Archives/edgar/data/1783879/000162828021013318/robinhoods-1.htm in the first quarter.

The U.S. Securities and Exchange Commission is now scrutinizing PFOF over conflicts of interest it says are inherent in the practice. WHAT IS PFOF?

Retail brokerages send the majority of their customers' orders to wholesale brokers, rather than to exchanges, because wholesalers generally execute the orders at a slightly better price than available on exchanges. Most retail brokers also accept rebates, or payments, from wholesalers in return for their customers' orders. HOW COMMON IS PFOF?

PFOF, which is disclosed in quarterly regulatory filings, has been a growing source of revenue for many brokers as retail trading volumes have surged.

Some retail brokerages, including Charles Schwab Corp and Robinhood, accept PFOF, while others, including Fidelity and Public.com, do not. PFOF is banned in Canada, the UK, and Australia.

Robinhood has said PFOF allows it to offer commission-free trading. WHY DOES IT MATTER?

The SEC is looking into whether PFOF creates an incentive for brokers to route customer orders to places that maximize PFOF rather than to the place that would get the customers the best execution.

Securities and Exchange Commission Chair Gary Gensler also recently expressed concerns that commission-free trading brokerages may encourage investors to trade more, in order to capture more PFOF, even if that is not in the investors' best interest.

IS REGULATORY SCRUTINY OF PFOF NEW?

No. PFOF has been around for decades and the SEC has historically focused on disclosure of the practice, but its growth in recent years, as commission-free trading models have become the norm, along with an associated increase in off-exchange trading, has led to renewed attention.

ISN'T FREE TRADING GOOD FOR EVERYONE?

In December, the SEC fined Robinhood $65 million for failing to properly inform its customers about PFOF it received that resulted in those customers paying higher prices to execute trades.

The regulator said certain wholesalers told Robinhood there was a trade-off between PFOF and price improvement for customers, and that Robinhood "explicitly offered to accept less price improvement for its customers in exchange for receiving higher" PFOF.

The SEC said the costs to Robinhood's customers "might have exceeded any savings they might have thought they'd gotten from zero commission trading." Robinhood settled without admitting or denying the charges. (Reporting by John McCrank; Editing by Steve Orlofsky)