SEC says brokers attracted by paying for order flow are making trading a game to attract investors

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The Securities and Exchange Commission said online brokers, seduced by the controversial industry practice of paying for the flow of orders to increase their revenues, are making stock trading a game to encourage retail investor activity.

Wall Street’s premier regulator released its highly anticipated report on the GameStop mania earlier this year on Monday. The 44-page report detailed how the trading frenzy subsided and raised red flags on a number of topics, including the back-end payments brokers receive, gamification of the trade, and disclosures on short selling. But it came close to blaming a single cause or entity.

“Paying for the order flow and the incentives it creates can encourage broker-dealers to find new ways to increase customer trading, including through the use of digital engagement practices,” SEC officials said in the report.

Paying for the order flow is one of the biggest sources of income at Robinhood, the millennials favorite stock trading app that gained a record number of new customers last year and went public in August. However, the practice is increasingly being scrutinized as many say it has a conflict of interest with brokers who have an incentive to send orders to the market maker who pays them the biggest discount. SEC chairman Gary Gensler had warned that banning this practice should not be off the table.

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

“It should be considered whether game-like features and celebratory animations, which are likely to generate positive feedback from trading, encourage investors to trade more than they would otherwise,” the report said.

Still, for some, the SEC review may not be sufficient to provide specific recommendations and lay the groundwork for potential changes in US trading practices. The agency also failed to reach a conclusion as to whether the trade – and the trading restrictions – were manipulative and whether brokers were playing by the rules during the mania.

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

Risk management and transparency

At the height of the mania in January, a group of amateur traders on Reddit’s WallStreetBets forum offered heavily short stocks “to the moon,” resulting in massive short squeezes on names like GameStop and AMC. The unprecedented volatility backfired Robinhood, tapping lines of credit and restricting trading on a list of short squeeze names as the Wall Street central clearinghouse mandated a tenfold increase in the company’s deposit requirements at one point.

“This episode underscores the essential role of clearing in risk management for stock trading, but raises questions about the potential impact of acute margin calls on broker-dealers with lower capital adequacy and other means of reducing their risk,” the SEC said. “One way to reduce the systemic risk of such companies to the clearing house and other participants is to shorten the settlement cycle.”

The SEC also raised whether there should be a need for more transparency on short selling. Currently, stock lending and borrowing is a relatively opaque system as investors do not have to report their bearish bets and the SEC only collects data on how many shares of a company are being sold short.

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

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

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