Best of Book

Payment For Order Flow (PFOF)
Is free trading really free for retail investors?

Euronext carried out a study on the practice of Payment for Order Flow:

• To protect retail investors, European regulators have implemented a law to limit a practice called “Payment For Order Flow”.  Payment For Order Flow involves a broker being remunerated for routing its own client’s orders (the investor) to a specific trading venue. This can be a trading platform or a select group of counterparties. Examples of such counterparties are Systematic Internalisers or High-Frequency Traders.
• The European regulation bans intermediaries from receiving any benefit, whether monetary or not, for routing client orders to a particular venue if it would create a conflict of interestTo get round this, some platforms have developed set-ups that indirectly benefit the intermediary. These set ups resemble a Payment For Order Flow model.
• One example is the ‘zero fee’ mechanism. Platforms offer free trading to intermediaries  sending orders from retail (non-professional) investors.  These platforms charge relatively high fees for accessing the platform to market makers (the firms who will buy or sell those orders). Market makers are happy to pay the platform fees since they will be the single counterparty to the trade. That means that they can choose the execution price and time of the retail investor’s order, giving them an advantage over the investor. This is in contrast to trading on an exchange, where multiple market makers compete to provide the best price for the investors.
• In these models, market makers ultimately benefit from a better execution price than retail investors. This practice is therefore unfavourable to retail investors. It does not meet best execution requirements.