Europe may have us beat for fashion, culture, and food. But we have a few things that Europe doesn't, like jam bands and Payment for Order Flow. What do these things have in common? Is it that they only make sense if you're on drugs?
Good guess, but not quite.
Here’s what it really is. Like a jam band, once you get past the noise surrounding PFOF, you realize the words are mostly nonsense.
(No offense, Phish. We kid because we love.)
PFOF on the other hand? We'd love to see it escorted from the venue by security. That shit is harshing our buzz, man.
There’s just something about shearing everyday investors for billions of dollars that rubs us the wrong way. Get outta here so we can enjoy this 40-minute drum solo in peace.
Obviously, you can tell we’re feeling the summer concert season. But let's drop the clumsy simile for just a moment to note that, in our views, PFOF is bad for retail investors and should be banned in the U.S.
If such an outright ban seems far-fetched, it's because we've been programmed to believe it. We need only cast our gaze across the Atlantic to see the truth—PFOF should and can be eliminated.
Rift
The European Union recently reached an agreement with its member states as part of its new updates to the MiFID rule regime. The new rule makes it illegal for brokers to send investor orders to wholesalers in exchange for payment. It represents a major step toward ending a practice that exploits individual investors and tilts the playing field towards high-speed internalizers.
It also casts the U.S. capital markets in even starker isolation, as the EU joins the UK, Canada, Singapore and Australia in outlawing the controversial practice.
Of course, you know how we Americans are once we get to drinking. We love to explain to anybody within earshot that U.S. capital markets are the envy of the world. Well, certainly that's true if you're a wholesaler like Virtu or Citadel. These market makers are center stage in our discussion.
In 2020 and 2021 alone, Citadel sent some $2.6 billion to brokers in exchange for order flow. Citadel CEO Ken Griffin’s net worth doubled to $32 billion over just that two year stretch.
So yeah, where Griffin is concerned, it's true that our markets are the envy of the world. But what about individual investors? As of today, international investors are far better protected than we are.
Stash
So now Payment For Order Flow is relegated to European history alongside the Prussian Kingdom and ABBA, right?
Well, sort of.
Much like ABBA, PFOF won't go away quite as quickly or as completely as you'd probably want it to.
While the new rules impose a general ban on PFOF within the EU, member states that already have PFOF arrangements in place will be exempt from said ban provided only clients within the member state are the beneficiaries.
Firms in these member states have two years to phase out the practice. That should give them plenty of time to pad their wallets before the party is over.
With that said, it does represent a big step toward providing greater investor protections. The new rule would prohibit brokers from offering zero-commission trades that are financed by payment for order flow.
As you might imagine, not everybody is happy about it:
A long time EU representative from Germany, Markus Ferber spoke harshly of the impact that the PFOF ban would have on European markets, arguing that "If you want to democratise access to finance and boost the Capital Markets Union, banning PFOF is precisely the wrong approach, and it is a huge disservice to retail clients.”
A fun bit of background on Heir Ferber. In 2017, he came under scrutiny for promoting and profiting from products that would help private companies navigate the MiFID II rules that he partially authored into EU law. Disciplinary action was considered but ultimately dismissed in 2018.
Anyway, that guy says that banning PFOF is bad. It's possible he changes his mind once he creates a product that helps companies navigate compliance with the new PFOF ban.
Until then, we'll assume he’s speaking from the business end of his lederhosen.
Character Zero
Indeed, Ferber’s claim is familiar to those of us in the U.S. markets who have grown accustomed to the same arguments. As the SEC pushes for regulation around Best Execution—regulation that we don't believe goes far enough—advocates for PFOF say that individual investors have the most to lose under the proposed rule change.
The argument goes like this:
Ergo, banning PFOF would hurt individual investors.
But like we said, once you get past all that noise, you'll realize this argument doesn't make a whole lot of sense.
And to quote the preeminent jam band, Phish once observed "Appletoast, bedheated, furblanket rat.”
Hard to argue with that.
The case against banning PFOF in the U.S. on the other hand? That's actually really easy to argue with.
Bag It, Tag It, Sell It to the Butcher in the Store
Stephen Hall, legal director and securities specialist at Better Markets says that retail investors are being hoodwinked. When broker-dealers sell our orders to wholesalers, these wholesalers do something called internationalization.
This means they trade our orders on their platform, regardless of whether we get the best price or not. Brokers like Robinhood are handing out "free trades” and sending our orders to companies like Citadel and Virtu.
As we explain in our own comment letter to the SEC, "Brokers who accept Wholesaler PFOF receive less price improvement, and the practice is incompatible with the duty of best execution. Brokers that do not accept any kind of PFOF route differently than brokers that do, and those brokers see superior execution quality.”
The long and short of it—you are the product. That's why you’re getting your trades “for free." Because you are being bought and sold by middlemen.
Big deal, you say? Now who's the buzzkill, amirite?
Surely, you say, we’re saving more than we're losing by getting free trades, right?
Actually…
“The collective damage is huge,” says Hall. “Billions of dollars go from the pockets of individual investors into the coffers of the big players every year.”
Of course, Hall works for something called Better Markets. He would think that.
Let’s ask somebody with a more favorable view of big players and their coffers.
Harry Hood
“The potential long-term impact of internalization is so corrosive to our national market system that the Commission should take every possible step to curtail the business practice.”
Go on…
“Internalization is one of the greatest threats to price discovery in financial markets.”
Interesting. What else?
“As more and more brokers engage in the practice of internalization, bid-ask spreads in the public markets will continue to be wider than they otherwise would, quoted liquidity will continue to fall and the role and value of public markets will be greatly diminished.”
Ok. Alright. We get the point. PFOF bad.
But you have to look at the source. I mean, what granola-munching, sandal-wearing, no-good hippie pinko said that shit?
You guessed it. Radical anti-capitalist Citadel CEO Ken Griffin.
But that was the old Ken Griffin. He wrote that stuff in 2004. Things are different now. As the Commission expands on its efforts to address the issues surrounding internalization and order flow, Griffin’s dissent has been among the loudest.
And his firm’s contributions to undermining the Commission have been among the most generous. Griffin explained in a 2023 comment letter regarding the SEC’s new Best Execution rules that "the Proposal is unnecessary, unjustified, and would have serious adverse consequences.”
He goes on to write that “The Commission does not identify—beyond ‘sheer speculation’—any real problem that is ‘worthy of regulation.’
Like we said, when you really listen to the words, they just don’t make a lot of sense.
Divided Sky
Ken Griffin once described Payment for Order Flow as “Unfair”, “Corrosive” “Conflict-Ridden” and “Counter-Intuitive”.
Now he's all like, “Let us hope that in Washington we maintain the status quo…That’s the basis on which we win.”
So what changed?
Well, in 2004 Ken Griffin wasn’t the richest man in Florida. Today, he is.
It's good to be the king, whether you prefer to collect boats, works of art, or congressmen.
Daniel Schlaepfer, CEO at Canadian trading and market-making firm Select Vantage observes with a relatively Canadian level of politeness that “The different approach taken by the US compared to the EU can in part be accounted for by the status of the US financial sector as the world leader in financial innovation, In practice this means that those select firms that have succeeded in capturing retail order flow through internalising schemes have greater influence on the government than they might in Europe.”
He's being nice-ish. He's really just saying that lawmakers in the U.S. are more likely to be owned by Wall Street lobbyists.
So the matter of PFOF—while now settled in the EU, UK, and Canada—remains very much in play in the U.S.
At Urvin, we've made it very clear that we believe PFOF should be banned outright, and we promise to keep banging on that drum until everybody gets it.
Dave Lauer is a co-founder and CEO of Urvin Finance, where he leads the team in building Urvin Terminal. Prior to founding Urvin Finance, Dave spent over a decade advocating for financial market reform after quitting his job as a high-frequency-trader.