March 26, 2021 Like PFOF for Chocolate Mark Davies S3 Follow | Profile | More Share When it comes to payment for order flow, the quality of trade executions is still very opaque – despite the fact that SEC Rule 605 reports show how well market centers perform. These reports do not help the average investor decide how and where to trade, writes Mark Davies, Founder and CEO of S3. And the only way for investors to know the quality of a trade is for this information to be publicly available. The SEC and Congress should focus on increasing transparency, not on banning PFOF or restricting other business models, Mr. Davies explains. You know that house at Halloween who gives away the full-size candy bars? Do you suppose they buy those from the gas station for $1.19? Probably not. More likely, they buy them at Costco. I bet they even use coupons. With that, they can get the price to about $0.30 per bar. Is your first reaction, “oh, they’re giving away junk candy – it only costs $0.30”? Of course not – it’s the same candy bar as the one you can buy at the gas station! But this is exactly the thought process being applied to the stock market these days. Why? Because everyone knows how much retail brokers are paid via Payment For Order Flow (PFOF), but no one knows the quality of their executions. SEC Rule 606(a) is the reason we all know how much PFOF brokers are receiving – it requires disclosure of the financial arrangements between brokers and the destinations that they route orders to. As a result, popular sentiment seems to be that if retail firms are getting paid to route their order flow to a certain destination, then they must be getting bad executions for their clients. There are many factors that come into play when determining quality of execution – size of the order, the specific stocks being traded, the time the execution occurs, and the limit price on the order are just a few of the things that affect execution quality. The notion that firms receiving more PFOF are delivering an inferior service to investors without understanding the quality of execution is absurd. With the chocolate, the quality is printed right on the wrapper – there’s nutritional information, ingredients, and a best-before date. But the quality of trade executions is still very opaque – sure, there are SEC Rule 605 reports that show how well market centers perform, but this doesn’t help the average investor decide how and where to trade. The only way for investors to know the quality of a trade is for this information to be publicly available. This is where the SEC and Congress should focus – increasing transparency, not on banning PFOF or restricting other business models. Transparency of quality, in tandem with the existing disclosures, is the only way to determine if conflicts of interest exist. Without this transparency, good quality efficient businesses are punished, and that’s not in anyone’s best interest. Photo Credit: “Halloween Candy” by Rochelle Hartman is licensed under CC BY 2.0 • • • Mark Davies is the co-founder and CEO of S3, a full-service regulatory compliance and trade analytics software company. He is a member of several industry groups that focus on market structure and compliance issues, co-chair of the FIF 606 committee, and an advocate for giving away full-size candy bars at Halloween. TabbFORUM is an open community that provides a platform for capital markets professionals to share their ideas and thought leadership with their peers. The views and opinions expressed are solely those of the author(s). They do not necessarily reflect the opinions of TABB Group, its analysts, TabbFORUM and its editors, or their employees, affiliates and partners.
No matter how transparent PFOF process might be, it still does not rule out the possibility of conflict of interest for the broker with its clients especially when there is non-arm's length business relationship between the MM who paid for the order flow and the broker when all of the orders are supposed to be sent to central exchanges to be executed. That was the deal. And even the execution quality cannot be said to be superior with PFOF. There is no way the execution quality could be better for the clients of the broker when the MM actively pays to the broker to execute trades and then still have to make a profit on the trades. If the MM has to pay to execute the orders and still gives the clients of the broker a better price than what can be offered by the central exchanges, WHERE and HOW is he going to make money??!!! Something's gotta give. The only scenario where I can see this PFOF may work out is 1) MM are banned from being owned by any brokerages or have any non-arm's length relationship through any subsidiaries, parent/child companies, board seats, family relationships or 10%+ share ownerships and 2) if the MM paid to the central exchanges for order flow. The brokers will send all of their clients' orders to central exchanges and then the central exchanges can allocate them to MM's according to how much they paid for order flows. This way at least there is price objectivity and impartiality and all clients' orders at least would have a fairer chance of competing with each other to produce price discovery. MM's should in no way shape or form pay directly to the brokers for order flows and internalize trades. It might still give the MM's the unfair advantage of knowing all overall price levels for potential market manipulations but that unfortunately is unavoidable as long as there are market makers allowed to be in the market structure. I mean it's them who "made" the market so they are essentially the market.