Hi, I hear a lot about the PFOF charged by discount brokers, which the US is planning to ban? What exactly is that?

Let me put PFOF (Payment for Order Flows) in simple terms. X is a low cost broker offering either zero brokerage or dirt cheap brokerage to its clients. Great, but how does it make money. They use a facility called PFOF. Large low-cost brokers in the US like E-Trade, TD Ameritrade and Robin Hood farm out a bulk of their retail traders to large market makers for execution and get a share of the revenues in return. The Securities & Exchange Commission (SEC) feels this distorts competition in the markets.

US SEC Chair, Gary Gensler, wants to make trading in the US markets more transparent and also fair. He would like to come down heavily on PFOF (payment for order flows) which most of the low cost brokers like E-Trade, Ameritrade and Robin Hood charge. If Gensler has his way, he would like to totally clamp down on PFOF, which his already banned in countries like UK, Australia and Canada. However, there is nothing barring PFOF in the US but SEC thinks that it is unnecessarily distorting the markets and deserves a rethink.

Here is how it will be done. SEC will try to increase competition for handling orders in the market by commission-free brokerages. There is no point if they call it commission free and then make trading expensive through the back door. That way, investors who trade on these low cost platforms don’t get a good deal. SEC is not comfortable with this system of low-cost brokerages accepting payments from wholesale market makers for orders in an opaque manner. SEC mandate is to either make it transparent or ban PFOF altogether.

However, banning PFOF in the US may be easier said than done. Most of the market players are averse to an outright ban on PFOF as they feel it interferes with the basic right of a low cost broker to operate profitably and offer better benefits to the end customer. However, the typical proxy firms and investor protection groups are with the SEC to ban PFOF altogether. The SEC may have to settle somewhere in between. But all is not stuck as the SEC Chair has also offered a middle path that would be more acceptable to all.

HE suggests that even if PFOF is still permitted, the SEC would want rules to mandate that market makers disclose more data. More so about the fees that they actually earn by farming out such trades to market makers. One risk in this entire exercise is that it could negatively impact the ability of brokers to offer commission-free trading to retail investors. Open and transparent auctions for better prices is one of the options suggested by the SEC. It remains to be seen how the middle path is finally chosen.