Opinion: regulators are missing the mark on PFOF
The revenue system saw heavy scrutiny after the rise in popularity of zero commission trading platforms
Reports came out this week that the US SEC would not ban payment for order flow (PFOF) systems in brokerages. By contrast, top lawmakers in the EU affirmed that a PFOF ban is still firmly on the cards. However, if the focus of regulators is investor protection, both approaches may be missing the mark.
For brokers using PFOF, revenues come not just from investors paying an execution fee, but also from market makers who pay brokers to have investors’ orders routed their way. For the most well-known neo-brokers like Robinhood, using the revenue from PFOF meant they could offer zero- commission trading for investors.
How PFOF should be handled has significantly split the market, with proponents touting its benefits of lower infrastructure costs for investors and lower spreads, which have boosted the accessibility of the capital markets to retail investors. By contrast, opponents refer to the potential conflict of interest arising from the model. Brokers could be tempted to route clients’ orders to a market maker that offers the highest PFOF rather than one that offers the best execution.
In August an academic study undertaken by the University of California concluded that there’s no evidence that PFOF harms price execution for investors more than other brokerages.
The study compared execution quality of six brokerage accounts across five brokers by generating a sample of 85,000 simultaneous market orders and found that across brokers, variation in PFOF could explain the large variation in price execution.
Researchers found the size of PFOF payment ranged from $0.001 to $0.002 per share, a tiny fraction of the observed variations in price improvement.
This suggests the problem is not so much PFOF itself.
Rather than banning PFOF, the SEC has issued rules stating that brokers cannot let PFOF interfere with their duty of best execution and has required extensive disclosures. However, according to the University of California study, this approach is lacking.
“Self-reporting is haphazard and inconsistent across brokers,” said the paper. “All brokers claim to provide price improvement over the National Best Bid Offer (NBBO) price, a benchmark that is easily beaten, albeit often narrowly.”
In the EU, the proposals to ban PFOF have been controversial, particularlyaround the equity consolidated tape. Instead of one wide-spanning approach, member states are tackling it in their own ways. In the Netherlands, PFOF is banned, whereas in Germany, the zero-commission brokers using the system have gained a large presence.
PFOF prompted a boom in retail investment, facilitated by these zero commission platforms and pushed by the breakdown of the statutory pension systems and sizable inflation since the pandemic which have encouraged people to find new ways to manage wealth. While it’s not clear when a compromise will be reached, a total ban waits in the wings in the EU.
However, both approaches seem to miss the mark.
It’s not necessarily PFOF itself that is hurting retail investors through a lack of best execution, but instead the gamification of investing apps and easily accessible trading without risk-education for investors.
Such elements blur the line between investing and gambling and put retail investors caught up in a gamified investing experience and social media trends at risk.
Furthermore, if the regulatory focus is on the welfare of retail investors, then a wider concern is the funnelling of order flows to dark venues in the first place – whether done by PFOF or not. The EU proposals are a good first step to shed some light on what’s going on between the retail broker and stock exchanges but don’t fully address the issue.
There are many areas which regulators could focus on to reduce risk for retail investors, but PFOF itself may not necessarily deserve to be at the top of the agenda.