A Simple Remedy for Payment-for-Order-Flow

Payment for Order Flow (PFOF) schemes are falling under increasing regulatory scrutiny for a very simple reason. Intermediaries pay for retail order flow because it is valuable. It is valuable because of an antiquated minimum pricing rule that mandates artificially wide spreads between bids and offers. This rule was derived from market practices that are now over 20 years old, and which predate modern electronic trading and market making.

This outdated rule allows intermediaries (usually hidden or “dark”) to utilize modern technology to notionally provide what is still considered regulatory best execution while pocketing the lion’s share of this de facto hidden tax for themselves and the brokers selling their clients’ order flow.

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 are a holdover from the era of manual market makers. They are established by regulatory fiat following lobbying campaigns between competing groups representing market makers on one side and investors on the other.

Essentially, they 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. Witness the proliferation of inverted markets. It conclusively proves our thesis. This artificial tax is also the prime motivation behind some of the more insidious dark markets and order types. It encourages practices that are parasitic to the fundamental price discovery mechanism underlying all efficient markets. It enriches a few hidden intermediaries at the expense of retail investors and damages the collective markets for all other participants.

Our simple remedy is to reduce the minimum pricing tick to a tenth of a cent. Why waste time fighting entrenched vested interests through market reform. Why not just take away the economic incentive and return it to its real owners, the investing clients?

The problems would largely be solved virtually overnight, with immediate results. Retail flow will return to the visible markets, the more insidious applications of dark orders embedded in lit books will be greatly reduced, and the natural bump in liquidity that ensues from a reduced transaction tax will benefit all investors. More fundamentally, retail clients will attain both higher sales and lower purchasing prices.

We need regulators with an understanding of the markets they oversee, with a firm grasp of the sometimes-obtuse elements of market structure principles, and with the self- confidence to stand up to entrenched vested interests and do what is right for the broader markets.

The fact that arguably the biggest such intermediary in the US has just come out with a recommendation to effectively cut their margin in half is pretty strong evidence that this is the right path. It also clearly demonstrates that there is further room for improvement. Drop the minimum tick to a tenth of a cent and let the open markets benefit all investors, not just a few participants.


Daniel Schlaepfer is the President and CEO of Select Vantage Inc. (SVI), one of the world's largest equity traders and de facto market makers on over 10,000 securities globally.

Ian Bandeen is Chairman of the Advisory Board of SVI and was a Founder and past CEO of the Canadian Securities Exchange.

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