No-Commission Brokers Could Be Affected By SEC’s Proposed PFOF Rule
Yesterday, the US Securities and Exchange Commission (SEC) proposed rule changes to revamp Wall Street’s handling of retail stock trading. The need for the new measures arose over doubt that retail investors were getting the best deals from their brokers after last year’s meme stock frenzy.
The proposed regulation aims to make the equities market more favorable and transparent for individual traders. Accordingly, the plan unveiled by the SEC’s chair Gary Gensler would bring about stiffer competition among trading firms. It would require brokers to compete directly to execute trades by retail investors.
Gensler Takes Aim At PFOF Model
The new proposal by the wall Street watchdog aims at the controversial payment-for-order-flow (PFOF) practice. It would be the most significant overhaul in the US Stock market in the last 15 years if passed. However, the SEC faces stiff opposition as TD Ameritrade, Robinhood Markets, E*Trade, and several other brokerages use the PFOF model. The model allows brokers to offer low-cost or zero commission trading while making money by retail investing data to market makers.
Consequently, the new guidelines would require market makers to publish more information about costs and trade timing for the benefit of investors. This is expected to substantially disrupt wholesalers’ business models while impacting the brokers’ ability to offer regular investors commission-free trading.
Additionally, it would boost order-by-order competition through “open and transparent” auctions to give investors better pricing. They would also include an agency-specific definition of best execution for stocks and other securities. This would ensure that broker-dealers and investors understand the procedure brokers must follow when managing and executing customer orders.
Finally, the guidelines would also aim to reduce the minimum pricing increment, or tick size, to better correspond with off-exchange activity. This guarantees that all trading occurs with the smallest increment possible.
What is the PFOF model?
The PFOF model is when wholesale market makers pay brokers, usually retail brokers, for their clients’ order flow. The model allows these market makers to trade profitably against client orders while the customers benefit from lower trading expenses. The discounted trading costs come because the wholesale market makers’ payments may reduce the fees retail brokers charge.
However, the practice is controversial, with many believing that it creates a conflict of interest in brokers’ best execution responsibilities to their clients. It also caused outrage in the US with a petition for its ban, gathering over 54,000 signatures in 2021. Gensler seems to be taking that stance with the new proposal after hinting at a possible ban. He revealed that he instructed his staff to develop an order-by-order auction process to enable retail traders to get the best prices for their transactions. He said,
“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges. It’s not clear, given the current market segmentation, concentration, and lack of a level playing field, that our current national market system is as fair and competitive as possible for investors.”
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New Rule to Significantly Impact Brokerages like Robinhood
The proposed rule will alter the business model for brokerages significantly. Retail brokers would have to transmit PFOF customer orders to the wholesaler who offers the best bargain, not the one who pays the most.
Consequently, this would radically alter wholesalers’ business models. They usually make more money by executing retail investor orders internally rather than dealing with other sophisticated trading firms or large investors on public exchanges. Retail investors will also now choose the highest offer when selling and the lowest price when buying.
Several analysts have come out in support of the SEC’s new proposal. Dave Lauer, CEO of financial platform Urvin Finance, has commended the regulatory body for its actions. He revealed that changes were necessary for different market parts as no single answer was viable. He said,
“We need an order-by-order standard for best execution and open competition for order flow to provide the best outcomes for retail investors. This will force greater competition and could help to end the off-exchange oligopoly that has controlled that market for too long,”
Meanwhile, for the proposal to pass, it would first require two votes by the agency’s commissioners to take effect. However, Gensler did not specify when he expected the recommendations he proposed to be released. If the agency’s commissioners favor the proposal, it will be made public for comment. Subsequently, the SEC will conduct another vote months later to approve the regulations after considering the public’s response.
Do you think the new proposals by the SEC would give retail investors an edge in the financial markets? Let us know your thoughts in the comments below.