TL;DR

The SEC had been considering outlawing Payment for Order Flow (PFOF) and have decided it’s still kosher, for the time being. It is well known that PFOF arrangements can create conflicts of interest between brokers and those they serve. Specifically, the broker has forces tugging on their obligation to provide the best possible execution (since, all other things being equal, the broker wants to maximize revenue from selling order flow). The U.S. can, and should, look to the countries that have already outlawed PFOF and seen corresponding improvements in market structure, with retail traders being offered better prices more consistently. 

Well folks, I guess it’s up to us to offer retail traders fair prices

The SEC has decided to not ban PFOF, having spent recent months deliberating on the appropriate action to take following the practice making headlines throughout and following the meme-stock craze. While firms such as TD Ameritrade Clearing and E*Trade are the largest PFOF beneficiaries, Robinhood has been in the limelight for the majority of the past couple of years in virtue of the focus on ‘democratization’ of markets and the relevance of commission free trades as a selling point to the masses.

Banning payment for order flow has been in and out of the public conversation for years. In 2004, an attorney for Citadel (a firm that pays Robinhood for access to order flow) by the name of Jonathan G. Katz wrote a letter to the SEC describing how “Payment for Order Flow (PFOF) creates serious conflicts of interest and should be banned”. The letter goes on to say: “Internalization without meaningful price improvement reduces competition, limits price discovery, leads to market fragmentation, and should be banned”. This is really what the entire discussion boils down to: is there a benefit for the retail trader? Adherents of PFOF argue that commission free trading depends on PFOF, however this is only the case if the savings on transaction fees are greater than the potential price improvement in a truly fair market.  

The intellectual gymnastics often performed to justify PFOF usually involve some reference to “increased liquidity”. Though this is somewhat meaningless unless we consider the question of “Liquidity for whom?”. If the uninformed retail trader isn’t getting a better price, then it is hard to see how this is an equitable arrangement. PFOF has been banned in the UK since 2012 and is also illegal in Canada. The cessation of Payment for Order Flow type arrangements in the UK in 2012 happily coincided with a significant improvement in quoted price quality. Between 2010 and 2014 “the proportion of retail-sized trades executing at the best quoted price increased from ~65% to more than 90%, suggesting the integrity of the order book has improved’ according to the CFA institute.  

At some point in the coming months the SEC is expected to publish new rules for the American equities markets (~$48 trillion). As we’ve written before, many have expected a potentially imminent regulatory reckoning for PFOF. However, recent news published by Bloomberg suggests that this reckoning might not come for some time yet. With the headline essentially being that the SEC is no longer considering banning PFOF, whereas this had been an option on the table in the recent past. On this news on Thursday September 22nd, 2022 both Robinhood and Virtu saw their stock increase in double digit percentage points (12% and 11% respectively).