One small step for the EU, one giant leap for retail investors

Following lengthy disagreements between Europe’s various decision makers surrounding the practice of Payment for Order Flow, the EU Commission – the European Union's executive body – has proposed a compromise through which PFOF will be banned, albeit in a targeted manner.

While the European Parliament had proposed banning the practice outright, some EU states including Germany wanted to continue allowing it, though with stricter restrictions.

In a bid to end the stalemate, the Commission has proposed a compromise, according to a document for a meeting of EU states that was seen by Reuters.

Under the proposals, there would be a general ban on PFOF in relation to retail customers, the document said.

A compromise certainly, but this also represents important progress in exactly the right direction.

PFOF, a practice through which brokers earn fees in return for directing stock trades to specific trading platforms, drew regulatory scrutiny in 2021 when an army of retail investors flocked to so-called meme stocks on Wall Street, using brokers who won business by charging zero fees – making money by sending orders to an agreed venue for execution, rather than looking for the best prices.

To understand why a ban on PFOF in relation to retails customers is desirable requires an understanding of the origins of the practice. Many years ago, old-fashioned floor traders demanded that a one cent spread be mandated to cover their risks in providing market-making services. However, today’s markets primarily use computers to provide liquidity on over 80% of the daily trading volumes. Unfortunately, regulators have not kept pace with this evolution.

So PFOF continues to flourish because regulators have mandated trading occur at minimum trading increments that are substantially wider than markets now require. In a perfect world, bids and offers would be at the same price, with only access costs to consider.

The principle should be to put the interests of the client first and to seek the best execution possible to effect the same; to promote market integrity and to bolster an efficient price discovery process. Instead, we have a rule which encourages participants to devise various means to undercut and abuse it.

As a result, wholesalers pay online brokers to redirect client business off the market where retail orders are held and matched, enabling the directing brokers and wholesalers to pocket the difference for themselves.

What seems like pennies can translate into the billions of dollars lost each year by the retail clients whose buy and sell orders were misdirected from the open marketplace and artificially mispriced. Fundamentally, PFOF finances the illusion of free trading to the detriment of retail investors.

If regulation followed first principles, the US and the UK should follow Europe’s lead in thinking seriously about banning the practice outright – as it already is in Canada – to the benefit of the broader market, especially the retail investor.

Instead, under its new Market Structure Reforms, the SEC proposes a set of complex and ultimately redundant rules.

The PFOF reforms would require that certain individual, retail marketable stock orders (orders seeking to be immediately executed at the best available prices) initially routed to the wholesalers (called restricted competition trading centers) be then routed to an open auction (called a qualified auction) at a specified limit price (a buy or sell stock price order threshold).

Furthermore, open competition trading centers, including national stock exchanges such as Nasdaq and the New York Stock Exchange (NYSE), and alternative trading systems (nonexchange, electronic trading systems regulated as brokerdealers, which includes dark pools) would operate the proposed auction.

Sound simple enough? I didn’t think so either.

But if the SEC won’t ban PFOF outright, here is a more elegant solution. Simply reduce the minimum pricing increment to a tenth of a cent. Once the incentive is removed, there will be no need for such complicated rules.

After all, what is a market if not an auction operated at maximum scale and efficiency?