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Tra la la.
For any who aren't yet familiar with the concept, PFOF ("Payment for Order Flow") is a practice whereby market-making systematic internalisers (ie, peeps who are so-o-o-o big in the world of trading that they actually have an inventory of stocks, ready to pull off the shelf for you) pay a commission to retail brokers to encourage them to direct retail orders for securities their way.
There now, you see! You're all ready fretting. Say whaaaat? *splutter* That... that, would be like Amazon or Facebook taking a payment from suppliers to lure consumers into their online stores with clever page layouts and whatnot, regardless of broad consumer benefit. Man the barricades!
Er, um...well...I'm not sure how to break this to you but...
Anyway, getting back to PFOF. There's a few of things you should know. First, it's a curiously American thing (a bit like tele-evangelism or Country music), which may mean that the US is behind or ahead on this. You get to decide. Here's the FCA (UK), on the same subject, nearly a decade ago:
‘Best execution and payment for order flow’. In TR14/13, we explained that PFOF in relation to retail and professional client business is incompatible with our rules on conflicts of interest and inducements, and risks compromising firms’ compliance with best execution.
Second, retail order flow is generally risk reductive for the market-maker (lots of small trades in randomised directions are broadly less risky than a few large bets precipitated by clever quant algorithms) and contributes to institutional stability, which arguably reduces risk in the market overall. Third, the normal outcome of routing orders to a systematic internaliser is a cheaper deal for the retail investor than would typically be obtained on a stock exchange. (The SI, when it receives an order, is simultaneously executing a purchase and a sale. This means that it can dispense with the exchange fee. Moreover, the SI can narrow the "spread" it would otherwise charge between bid and offer prices because retail trades carry less risk and potential exposure for a market-maker than the large volume trades that may take place at the prices it quotes on an exchange.)
Okay, so what do you think now? Hmm... yes, very astute. I think you're probably right.
There's a bunch of research and analysis suggesting that PFOF may lead to less liquid and more fragmented regulated markets overall--in effect pitting the interests of retail day-traders (eg, GameStop investors) who typically take advantage of PFOF against the interests of fund beneficiaries (eg, pensioners-to-be) and any retail investors whose transactions are being executed on an exchange. And there's other research indicating that PFOF impairs price discovery in the market: pitting the value of institutional stability against the value of market efficiency. But important as unintended "invisible hand" wealth transfers and market inefficiencies may be, they're not the primary business of securities regulators; and, conversely, "banning things" is not the optimal method of guaranteeing fair and effective markets (at least where the "things" in question are of multilateral-and-mutual advantage to consenting adults). Remember: the three sets of interests at issue are, if not convergent, then mostly travelling in the same direction: the broker gets a kickback (or profit share, if you prefer); the market-maker gets to avoid exchange fees; and the average customer gets better-than-NBBO execution.
So, price discovery can't be what's gotten you all hot under the collar. No, it's the fact that the retail broker's interests will likely diverge at some point from those of the retail customer and that's a bit of a puzzler, aka a conflict of interests. Like when the broker decides to adopt a trade-frequency or a trade-volume business strategy to maximise PFOF revenues rather than one based, say, on maximising client numbers or market share--and then decides to introduce "gamification" to the brokerage platform and algorithmic patterning designed to overcome psychological resistance.
Another opportunity for the conflict to arise is when a competing market-maker enters the field offering execution at the same or better prices and/or offering a smaller/zero commission to the broker. 🎵I've got a girl, but you look good tonight.🎵** No matter whether the new SI is willing to pass the whole saving onto the retail investor or simply keeps the profit for itself, this is always a better option for the retail investor (who, at the very least, acquires a broker comparatively free from "complicated" incentives).
And there's more but, wait.... is this all getting a bit serious? TLDR? Conflicts of interest may also crystallise around--
points of contact with third party service providers, including clearing and settlement services: eg, strong incentives to maximise trade volumes may tempt brokers to take risks around provisioning for collateral calls;
the imminent bankruptcy of the market-maker; and/or
events of market disruption, extreme market volatility and/or a liquidity crisis.
And, it's important to note that, although an SI will normally offer better execution on price than an exchange, it won't necessarily always do so.
So, assuming we're agreed--a conflict of interest, like an abscess, is best lanced before it gets out of hand--what's to be done?
There are broadly three ways of dealing with this kind of conflicts of interest: 1) disclosure (on request or upfront); 2) mandatory optionality ("If you proceed, your transaction will be executed internally by a securities firm. For an account of the risks please click here. To be routed through an exchange please click here."); or 3) prohibition. To date, the SEC has opted for the first of these...sort of. Baby, d'ya wanna take a look at 17 CFR § 242.606 - Disclosure of order routing information, with me? No? You surprise me. The Reader's Digest version then?
(2) A broker or dealer shall notify customers in writing at least annually of the availability on request of the information specified in paragraph (b)(1) of this section
There you go. Retail customers can request routing info for execution and will be reminded of this fact about once a year.
Is that the right approach? Well, let me end by telling you what happened last time I spotted a pair of size 35 black Louboutins at better-than-half-price in an online sale. I remembered that I'd had a letter from Shoe Depot last October notifying me that other purveyors of designer shoes exist and that terms and conditions with respect to postage can vary. So, I left the site and researched my delivery options for 30 minutes before choosing a different store with a CIF shipping policy... by which time, unfortunately, the shoes were marked back up to MRP.
Did I 'eck as like.
* With apologies to songwriters: Morgan Taylor Reid / Sean Maxwell Douglas / Rudolph Slade Echeverria / Gregory Robert Garrity / Michael Hahn Kitlas. 18 lyrics © Tenyor Music, Songs Of Chmi
** Songwriters: Jordan Montell Du'sean / Palmer Brian O / Korduletsch Juergen S / Evers Joerg / Benbow Darren Todd / Wilson Le-var A. Get It on Tonite lyrics © Kohaw Music, Chappell Und Co Gmbh Co Kg
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