PFOF practice creates a substantial conflict of interest between broker-dealers and their customers

18 Feb, 2021 02:09
source: Singularity Financial

Singularity Financial Hong Kong February 18, 2020 – Famed venture capitalist Bill Gurley brought attention to the practice in a series of tweets Sunday, where he pointed out that Payment for order flow (PFOF) “creates an obvious and substantial conflict of interest between broker-dealers and their customers.”

Market makers have huge upfront costs, including technology, infrastructure, data and PFOF. After all four of those expenses, they still turn a profit from trading against a customer even though they have no significant financial exposure themselves for any period of time.

“Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution,” said the SEC in a study.

The SEC “needs to stop brokers from accepting payments for routing their customers’ orders to certain traders and exchanges,” the Michigian Democrat wrote in an op-ed in the Financial Times last month. “It is like paying a hidden, private tax on savings whether someone invests through a large mutual fund or directly through a personal brokerage account.”

What is Payment for Order Flow?

Payment for order flow (PFOF) is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. The brokerage firm receives a small payment, usually fractions of a penny per share, as compensation for directing the order to a particular market maker. For options trades, the market is dominated by market makers since each optionable stock could have thousands of possible contracts in existence. Payment for order flow is basically ubiquitous for options transactions and averages less than $0.50 per contract traded.

PFOF is a practice that U.S. regulators have condoned for more than thirty years, and an abrupt change in its stance toward it is unlikely and would face court challenges, according to Amy Lynch, a former SEC regulator and president of FrontLine Compliance.

“The SEC and FINRA have inexplicably allowed payment for order flow to continue for years,” said Tyler Gellasch, executive director of Healthy Markets, a nonprofit consortium of pension funds that advocates for rights of investors.

“Payment for order flow is not new,” she said. “The practice in and of itself is widely accepted, widely used and completely legal.”

Equity and options trading has become increasingly complex with the proliferation of exchanges and electronic communication networks (ECNs). Ironically, payment for order flow is a practice pioneered by Bernard Madoff—the same Madoff of Ponzi scheme notoriety.

In a particular payment for order flow scenario, a broker is receiving fees from a third party, at times without a client’s knowledge. This naturally invites conflicts of interest and subsequent criticism of this practice. Today, the SEC requires brokers to disclose their policies surrounding this practice, and publish reports that disclose their financial relationships with market makers, as mandated in 2005’s Regulation NMS.

Your brokerage firm is required by the SEC to inform you if it receives payment for sending your orders to specific parties. It must do this when you first open your account as well as on an annual basis. The firm must also disclose every order in which it receives payment. Brokerage customers can request payment data from their brokers on specific transactions, though the response usually takes weeks.

The cost savings from payment for order flow arrangements shouldn’t be overlooked. Smaller brokerage firms, which can’t handle thousands of orders, can benefit from routing orders through market makers and receiving compensation. This allows them to send off their orders to another firm to be bundled with other orders to be executed and can help brokerage firms keep their costs low.

The market maker or exchange benefits from the additional share volume it handles, so it compensates brokerage firms for directing traffic. Investors, particularly retail investors, who often lack bargaining power, can possibly benefit from the competition to fill their order requests. However, as with any gray area, arrangements to steer the business in one direction invite improprieties, which can chip away at investor confidence in financial markets and their players.