US Regulator wants to ban PFOF trades and here is what it means

Regulation is always work-in-progress anywhere and the US capital market regulator is no different. In a recent statement by the US SEC Chari, Gary Gensler, there is a move to make trading in the US markets more transparent and also fair.

One of the casualties cold be PFOF (payment for order flows) which most of the low cost brokers like E-Trade, Ameritrade and Robin Hood charge.

Now SEC wants to clamp down on this particular charges as the SEC feels that this was distorting the market through an opaque mechanism. The broad intent is quite clear. The SEC will try to enhance competition for handling orders in the market by commission-free brokerages.

This will ensure that small investors who trade on these low cost platforms actually get a good deal. They should not end up paying a big price through the backdoor, which they are not fully aware of. US equity markets are worth $45 trillion so any regulatory change is going to have far reaching impact.

But, back to PFOF (pay for order flow). What exactly is this? Under the PFOF, brokers (mainly the low-cost brokers) get paid to send customer stock orders to market makers.

In the US, some of the biggest low-cost brokerages like TD Ameritrade, Robinhood Markets and E-Trade accept these payments from wholesale market makers for orders. Last year, Robin Hood was actually penalized for this practice as it raised costs for investors.

Even in the US, the PFOF is not practiced across the board by all the large brokers. For example, there are many low cost brokers that do not indulge in PFOF. While this PFOF is still legitimate in the US, it is already banned in countries like Canada, United Kingdom and Australia.
 

However, banning PFOF may not he all that simple as it is a normal practice and banning could distorting the free pricing logic that is inherent in the market. Most of the market players are averse to an outright ban on PFOF. 

Most of the proxy firms and the investor protection firms have praised the SEC for the proposal to ban PFOF altogether. They believe it would be the biggest shake-up of US equity market rules in more than 10 years.

However, industry insiders are not too happy with such discrete solutions. They believe that PFOF could end up hindering the commission-free brokerages from serving more investors. They believe that in the process, the investors would end up being the major losers.

However, Gensler has offered a more of a pragmatic middle path. He says that even if PFOF is still allowed, the SEC would certainly want rules to mandate that market makers disclose more data about fees that they actually earn by farming out such trades to market makers.

If the SEC goes ahead, it could largely alter the business model of wholesalers. They could also affect the ability of the brokers to offer commission-free trading to retail investors. If the SEC has its way, then there cold be open and transparent auctions for better prices.

What does this mean?

It would require broker-dealers and market makers to disclose more data, including a monthly summary of price improvement and other statistics. Also, the retail brokers like Robin Hood and Ameritrade may not be able to send customer orders directly to a wholesale broker to be executed, unless they are bettering the price. Hopefully, this should set the tone for more far reaching changes to the US capital markets.