Payment for order flow

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Oh lord, where to start. PFOF was a big deal in Europe for years, and the Americans — usually such fastidious over-regulators — have been strikingly blasé about it. Much of the American love of playing the markets depends on it, in point of fact. All this was brought into sharp, public relief, in the great market un-crash of January 2021, when the massed armies of the investing public — for so long a huge, docile cow, tethered to the stall and irretrievably wired into the great financial services milking machine — woke up and decided to have things their way for once. Millking machine reacted rather petulantly. In a turn of events that is rather characterising the digital revolution, they discovered they were the product, not the customer, and the means of that transmission was payment for order flow.

What is PFOF?

The theory is — ought to be — when your order is filled you pay your broker a commission. Your broker has all kinds of regulatory obligations — the key ones are generally lumped together and called “best execution” — to make sure you get the best price available. This keeps the broker honest.

Okay. Now a broker fills your order by going to the market. In practice this means The broker will interrogate market makers, exchanges and other sources of market liquidity (multilateral trading facilities dark pools and so on), to identify that best price, retrieve it and bring it back for you.

Note the inherent asymmetry here: on one side of the broker millions of tiny investors, Each paying teeny commissions. On the other side, a small number of market intermediaries, each of Home hopes to handle a vast volume of transaction, charging even teenier commissions, but in such colossal quantities that in aggregate it makes a lot of money.

The more order flow an market-maker gets, the more money it makes. Like brokers, market-makers are agents: they do not take a principal position, but merely route customer orders to the market. Their revenue is an annuity: it depends on volume. Market-makers will (if they are allowed to) happily pay “retrocessions” for volume to individual brokers. They pay, in other words, for order flow.

They are allowed to in the US; they are not in the UK. The FCA banned payment for order outright about five years ago on the theory that it undermines transparency and efficiency, is inimitable to the idea of best execution, and also it creates a perceived conflict of interest between broker and clients.

In the US the dynamic is very different. Payment for order flow allows the retail platforms (Ameritrade, Schwab, eToro, RobinHood etc) to offer commission free trading. Like in Vegas, if the drinks are free, you are paying some other way. Most retail folks are happy enough with that trade: brokers have to disclose their PFOF arrangements. Sunlight is the best disinfectant, right? But for the most part the conflict of interest is more optical than fundamental: neither the broker nor the market-maker has a dog in the fight: as long as the trade gets done, everyone gets their little nibble on the client’s parcel and all is well in the world.

The GameStop market un-crash of 2021 has highlighted, starkly, that conflict of interest becomes a bit more visceral when it turns out the market maker’s brother has a dog in the fight. Some market-makers are part of bigger financial services organisations, and may also have a broker-dealer, an asset manager and even — [[dramatic look gopher —a hedge fund in the same market. Now if the hedge fund is short a stock that retail markets are buying like crazy through the trading platform then — hold on tiger. If all the long interest is coming through the retail platform, and all the short interest is institutional, then if the activity on the platforms can be dampened somehow — you know, by the platform suddenly shutting down the ability for punters to put risk on, and only allowing them to take risk off — that makes the job of shorting the shit out of the market a lot easier.

UK regulation

Well, the FCA has been commendably plain in its guidance.

The FCA considers PFOF to be bad for our markets and a direct risk to all three of the FCA’s operational objectives for the following reasons:

• It creates a conflict of interest between the broker and its clients because the broker is incentivised to pursue payments from market makers rather than to provide best execution in the interests of its clients.
• It undermines the transparency and efficiency of the price formation process. This is because the prices paid by clients include hidden costs – and whilst clients may be aware of the level of commission they pay to their brokers – they might not be aware of the higher spread that they may additionally need to pay to take account of the fees paid by the market marker.
• Forcing market makers to ‘pay-to-play’ can distort competition by creating barriers to entry and expansion. Indeed, if brokers refuse to look beyond fee-paying market makers, the most obvious way for new market makers to enter the market is to offer payment for order flow that is higher than the rates paid by existing market makers – an outcome that is inconsistent with promoting effective competition in the interests of consumers. Our supervisory work indicates that, for the most part, brokers routinely exclude non-paying market makers. This approach can result in poorer price outcomes for clients because, in addition to the wider spread that the client is likely to pay to account for the fees paid by the market maker, these ‘non-paying’ market makers might otherwise provide the most competitive pricing.

As of September the FCA has concluded:

• The large integrated investment banks have largely stopped charging PFOF in respect of all client business and across all market segments. (This is as close as a regulator will ever get to saying “hooray for investment banks”!)
• Independent brokers have mainly stopped charging PFOF to professional clients.
• Some independent brokers continue to charge market makers commission in return for order flow in respect of ECP initiated business. Here, the FCA still believes purported management of inherent conflicts of interest in PFOF are inadequate in light of SYSC 10. Nor would they satisfy the expectations under MiFID II.

See also

• GameStop and the great market un-crash of 2021
• Conflict of Interest

The FCA's FCA Marketwatch 51 released on 1 September 2016 — from which the above is extracted — should give you what you need. If that isn't enough, have a look at the FCA's original Thematic Review TR 14/13 of best execution and PFOF.

• Inducements and the rule against them.