Taming the force behind the US retail frenzy
And lately, PFOF has been the trick that has enabled the Robinhood trading app to offer its clients commission-free trades. Robinhood simply sold its retail client orders to market makers and hedge funds, such as Citadel.
PFOF looks more sinister than it actually is and there are legitimate reasons why it might be in the best interests of the end customer. By law, brokers must trade at the best executable price.
Follow the flow of retail
The execution of orders from retail investors is the most valuable type of transaction for market makers as it is considered the least toxic to them. A market maker makes money by crossing the spread: by buying at the offer price and selling at the offer price.
To make money, they need a lot of transactions, but these transactions also should not interfere too much with the buying and selling prices.
High frequency traders tend to play with the price, and institutional investors often break large trades into smaller chunks, pushing the price in one direction at the expense of market makers.
The retail flow is cleaner. Transactions are smaller, slower, and have a lower impact on the price, allowing market makers to capture the spread.
That’s why Robinhood and Wall Street market makers like Citadel are a perfect match.
Proponents point out that competition between large market makers has resulted in a 25% improvement in the spreads between bids and bids.
But the Securities and Exchange Commission appears to disapprove of this practice and on Tuesday, in an interview with Barron, the regulator’s enforcement official, Gary Gensler, revealed that the PFOF ban was “on the table.” Robinhood’s share price fell 7 percent.
Flash in the pan
The practice of PFOF has been the subject of debate in Australian regulatory circles in recent times. Last week, the Australian Securities and Investments Commission released a consultation paper on the subject with a view to toughening its rules.
In 2013, ASIC took a hard line against PFOF, saying it created conflict between participants, forcing them to orient their activities towards paid counterparties who might not offer their customers the best price.
So when Michael Lewis Flash Boys sparked controversy over it a year later, ASIC sat down and said “nothing to do here.” Australia, along with the UK and Canada, are banning PFOF, a point Gensler raised in Barron.
“I bring this up because [banning] it’s on the table. It’s very clear.
Now, as other regulators consider restricting PFOF, ASIC feels validated and wants to tighten the rules.
As it is, those defined as market participants cannot pay or be paid for the order flow. But the possibility exists for non-participants to pay for orders, or for agents to join the chain.
Thus, ASIC tries to stay ahead of any creativity by filling these gaps.
The ASIC article examines market integrity issues that it says validated its position.
“We consider that any benefit obtained from lower brokerage facilitated by
the payment of the order flow would be more than offset by a poor execution price,
and negative impacts on liquidity and market integrity.
ASIC noted that if PFOF were introduced, it would reduce brokerage costs, potentially to zero. This would make it cheaper for clients with smaller balances and more regular contributions to rebalance their portfolios.
But the GameStop fiasco raised another issue: the so-called gamification of trading. This, he says, could come at a cost to the “financial well-being” of those in the market.
Further reductions in brokerage costs that disruptors welcome may “encourage retail investors to over-trade or adopt a short-term gambling mentality rather than longer-term accumulation.”
Some in the market believe that PFOF has its merits. And it remains difficult to accept that transactions are more expensive just to discourage excessive transactions.
PFOF advocates say this has helped reduce retail execution prices by about 30 percent. But others, like a company named BestEx, say it creates a 40% profit margin and increases transaction costs for institutions, many of which invest on behalf of retail investors.
It is a complex debate which is part hypothetical, part mathematical and part philosophical.
But SEC Gensler and ASIC commissioners have made their position clear.