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All eyes turn to SEC as EU finally bans PFOF

Last Thursday, the European Union said that member states and the European Parliament had reached a deal on updating the bloc's MiFID-related securities trading rules.

The EU has been reviewing its rules to reflect advances in trading technology as well as the departure of the United Kingdom from the bloc, presenting new competition to EU markets.

"The agreement reached today imposes a general ban on 'payment for order flow' (PFOF), a practice through which brokers receive payments for forwarding client orders to certain trading platforms," a statement from the EU member states' council said.

I’ve long argued that this is the correct course of action, and long overdue. PFOF is able to finance the illusion of free trading by turning the retail investor into the product.

All eyes now turn to the SEC, whose new Market Structure Reforms seek to mitigate the negative externalities of PFOF through a set of complex auction rules instead of simply following first principles and banning the practice outright. Perhaps the EU’s decision will give them pause for thought.

In essence, PFOF is an outdated rule which allows brokers to utilize modern technology to provide what is still notionally considered ‘best execution’, while pocketing the lion’s share of this hidden tax for themselves.

What seems like pennies actually translates to many billions of dollars each year that retail clients would otherwise have earned for themselves through higher sale prices and lower purchase prices.

Conservative estimates are that these de facto transaction taxes are costing American investors well over US$10 billion per annum. It also means that close to 50% of US orders never see the light of day and the resulting reduced liquidity hurts all participants.

These minimum pricing increments represent the compromised minimum fee demanded by liquidity providers. Over the last 50 years, this fee went from a quarter, to an eighth, to 6.25 cents, and then to a penny in 2001. Not surprisingly, each time this tax was reduced, liquidity increased.

There is ample evidence that a penny is too wide and commercially unjustifiable. One need only witness the proliferation of inverted markets.

Failing an outright ban, the simple remedy I’ve previously called for would reduce the minimum pricing tick to a tenth of a cent. This would return retail flow to the visible markets, while the natural bump in liquidity that ensues from a reduced transaction tax would benefit all investors.

Most importantly, retail clients would attain both higher sales and lower purchasing prices.


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