Payment for Order Flow (PFOF) has long been a contentious topic in the world of finance. This practice, where brokers receive payment from market makers for directing orders to them, has different applications and regulations across various countries. This article delves into the PFOF landscape in the United States, United Kingdom, Europe and Australia, outlining key regulatory standards and financial instruments involved.
In the United States, PFOF is legal and widely practiced, but it’s subject to regulations from the Securities and Exchange Commission (SEC) [1]. Brokerage firms are required to disclose their PFOF agreements to clients, a practice instituted under the SEC’s Rule 606 [2]. One of the most common financial instruments associated with PFOF in the US is equities, particularly for retail investors using commission-free trading platforms. As these platforms primarily generate revenue through PFOF, this has resulted in high-frequency trading firms making up a significant portion of the market’s trading volume [3].
However, concerns have been raised about potential conflicts of interest, and in the aftermath of incidents such as the GameStop frenzy in early 2021, there have been calls for further regulation and oversight of PFOF [4]. A growing number of critics argue that PFOF can create an incentive for brokers to prioritize their own profits over the best execution of their clients’ orders, which is a violation of their fiduciary duties .
In the United Kingdom, PFOF has been largely restricted since 2012 by the Financial Conduct Authority (FCA). The regulations primarily focus on ensuring best execution for client orders . This prohibition is mainly due to concerns about conflicts of interest that can arise when a broker receives payment for routing orders to particular market makers. These restrictions apply to a broad range of financial instruments, including equities, derivatives, and bonds.
Yet, the use of PFOF in the context of wholesale market-making activities is permitted in the UK, provided the arrangement is transparent and doesn’t impair compliance with the overarching obligation of achieving the best possible outcome for clients .
Australia offers an interesting case study on PFOF. The Australian Securities and Investments Commission (ASIC) does not explicitly ban PFOF, but brokers are obligated to ensure that they act in the best interests of their clients, which may be compromised by a PFOF model. These rules apply to a wide range of financial instruments, including equities, derivatives, and fixed income products. Still, Australia’s specific stance on PFOF remains somewhat unclear, with ASIC considering further clarifications and potential restrictions in line with the evolving global landscape .
The practice of PFOF in the European Union is regulated by the Markets in Financial Instruments Directive (MiFID II) [5]. The directive, implemented in January 2018, has a clear stance on inducements and conflicts of interest that effectively bans PFOF.
MiFID II prescribes that investment firms must act in the best interests of their clients. Any fees, commissions, or monetary benefits paid or provided to or by a third party in connection with a service provided to a client must not impair the firm’s duty to act in the best interests of the client [6]. The regulations apply to a range of financial instruments, from equities to derivatives, bonds, and other securities.
However, a specific exception in MiFID II allows for what is known as “minor non-monetary benefits,” which could theoretically include certain types of PFOF, but this exception is narrow and its interpretation can be subject to national regulation and oversight [7].
The broad restriction on PFOF in the European Union is largely due to the same concerns seen in other jurisdictions: the potential for conflicts of interest that could result in sub-optimal execution for clients. Yet, the situation in the EU is evolving, with the European Securities and Markets Authority (ESMA) continuing to monitor the effects of MiFID II and consider potential adjustments [8].
In conclusion, the practice of Payment for Order Flow varies greatly between these countries, driven by different regulatory approaches and market structures. As regulatory bodies continue to adapt to the changing financial landscape, PFOF will likely remain a heavily debated topic, potentially influencing how retail investors trade and how markets function worldwide.
References:
[1] SEC. (2021). Payment for Order Flow. U.S. Securities and Exchange Commission. Retrieved from https://www.sec.gov/fast-answers/answerspfofhtm.html
[2] SEC. (2020). Rule 606. U.S. Securities and Exchange Commission. Retrieved from https://www.sec.gov/divisions/marketreg/mrfaq606.htm
[3] Menkveld, A.J. (2013). High Frequency Trading and The New-Market Makers. Journal of Financial Markets, 16(4), 712-740.
[4] Huang, D. and Kiernan, G. (2021). The Game
[5] European Commission. (2018). Markets in financial instruments directive (MiFID II). Retrieved from https://ec.europa.eu/info/law/markets-financial-instruments-mifid-ii-directive-2014-65-eu_en
[6] European Securities and Markets Authority (ESMA). (2017). MiFID II: ESMA issues final guidelines on the management body of market operators and data reporting services providers. Retrieved from https://www.esma.europa.eu/press-news/esma-news/mifid-ii-esma-issues-final-guidelines-management-body-market-operators-and-data
[7] Simmons & Simmons. (2018). MiFID II – Inducements and research. Retrieved from https://www.simmons-simmons.com/en/publications/ck2r32kqobosb0b96zfg5d31n/mifid-ii-inducements-and-research
[8] European Securities and Markets Authority (ESMA). (2022). ESMA to focus on MiFID II implementation and supervisory convergence in 2023. Retrieved from https://www.esma.europa.eu/press-news/esma-news/esma-focus-mifid-ii-implementation-and-supervisory-convergence-in-2023
