It looks as if the controversial payment for order flow (PFOF) practice is finally on its way out in Europe, with a draft report on Mifid II amendments confirming the proposed ban. Written by senior EU lawmaker and Polish MEP Danuta Hübner for the European Parliament, the report outlines detailed recommendations for updating EU legislation, taking a firm stance on PFOF despite recent rumours that the EU could be dialling back on its decision.
According to Hübner, concerns over PFOF were symptomatic of a wider problem across the EU of regulators interpreting rules differently and that “the rapporteur maintains the initial proposal” from the European Commission to ban the practice.
PFOF occurs when an investment firm (typically a broker) that sources liquidity and executes orders for its clients receives payment from the counterparty the trade is executed, as well as from the client originating the order – a practice that opponents are concerned can create a conflict of interest between the firm and its clients, because it incentivises brokers to execute client orders based on the willingness of counterparties to pay commissions.
In November 2021, the European Commission proposed plans to prohibit PFOF for high-frequency traders organised as systematic internalisers, as part of its Capital Markets Union update. Under the changes, venues will instead have to earn retail order flow by publishing competitive pre-trade quotes in yet another move to level the playing field between execution venues.
However, there have since been rumblings that these proposals could be scaled back. At TradeTech in Paris earlier this year, Tilman Lueder, head of the securities markets unit at the European Commission, implied that regulators could in fact be set to ease PFOF restrictions.
“Since we proposed [the] ban we’ve learned a lot. Whoever proposes any kind of legislative changes to PFOF will make themselves a hostage to fortune. You start with big ideas but you discover lots of detail on how it is used in different markets and I think it’s fair to say PFOF is used in a different manner in Europe as it is in the US,” Lueder explained to the audience of a regulatory keynote panel.
“Some member states see PFOF as positive because it allows smaller platforms to aggregate order flow and execute outside of the big exchanges and in terms of explicit costs that’s certainly cheaper and in terms of the implicit costs, that’s open to debate,” he continued.
It’s a controversial question, and one in which regulators vary in approach, with many taking a firmly opposing stance.
“PFOF makes it more likely that extra costs will be passed on to the broker’s client, through wider bid-ask spreads from market makers and other liquidity providers who agree to pay PFOF to attract order flow from brokers,” said the UK’s Financial Conduct Authority (FCA) in a 2019 review.
“While the impact of PFOF may not be visible in bid-ask spreads for each transaction, it is likely to affect aggregate spreads as liquidity providers need to account for the payments made to brokers. These hidden costs make the price formation process less transparent and efficient.”
PFOF is already banned in the UK and Canada, with the UK’s FCA stating 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.”
By comparison, it is both popular and widespread in the US (where it has been instrumental in the explosion of commission-free trading platforms such as Robinhood). However, in signs of growing momentum towards global convergence, there have recently been suggestions that the Securities and Exchanges Commission (SEC) could also take steps to restrict the practice. According to former SEC commissioner Michael S Piwowar, an outright ban is unlikely but new limitations are unavoidable. “Doing nothing is not an option,” he stressed.
Back across the pond, PFOF is also not yet legally banned in Europe, where Germany enthusiastically heads up the pro-camp, although many other member states oppose it. Hübner’s firm stance in the latest report suggests that despite Lueder’s earlier comments, the anti-faction may yet win the day.