Germany tells EU to PFOF

The absence of evidence is not evidence of absence. Should a life-saving drug be subjected to rigorous testing, or assumed to be safe unless proven otherwise? This is the dilemma faced by European Union lawmakers over the practice of payment for order flow (PFOF), where brokers receive payment for executing orders with certain market-makers.

Retail broker Robinhood’s decision to halt trading in the shares of GameStop at the height of last year’s meme stock frenzy thrust PFOF into the spotlight in the US. Opponents of the practice say it creates a conflict of interest for the broker, which may prioritise collecting the payments over securing best execution for its clients.

But how do you prove PFOF is actually harming retail clients? In the US, brokers and regulators can use a consolidated tape for equities to verify if best execution is being provided. In the EU, that tape doesn’t yet exist – and a leaked document obtained by Risk.net suggests the legislation intended to create it could now become mired in the PFOF debate itself.

The problem is that major market participants in one country stand to lose from either the ban on PFOF, or the consolidated tape; and the country in question is Germany – the largest EU member. But while it might not be able to block changes to Europe’s vital Markets in Financial Instruments Regulation (Mifir) on its own, it will wield considerable influence with other EU members when it comes to negotiating a compromise on the final package.

A real-time consolidated tape is an obvious way to build more integrated capital markets across the EU, by providing a golden source of share pricing data for all participants. But it would also make the market data sold by Germany’s national champion exchange, Deutsche Börse, less valuable.

Meanwhile, the PFOF debate in Europe should be simpler than in the US. Most EU member states have already banned the practice as an inducement to trade – which is forbidden under the directive that accompanies the existing version of Mifir. But PFOF is flourishing in Germany. And if anything, the German format raises even more concerns about fair competition and best execution than what happens in the US.

The problem is that major market participants in one country stand to lose from either the ban on PFOF, or the consolidated tape

New online retail brokers in Germany have been executing their orders on regional exchanges that also own the sole market-maker operating on their platform. As a result, there is no competition on these platforms to show best-pricing to the retail customers of the brokers that are receiving PFOF.

Germany is using research studies to fight back. Shortly before the European Commission released a package of draft Mifir reforms proposing a ban on the practice in November last year, a study commissioned by Trade Republic – a leading neo-broker that receives PFOF – concluded that the arrangement leads to the best outcome for investors when execution prices and service charges are taken into account.

Since then, counter-studies released by Dutch and Spanish regulators have argued that prices of Dutch and Spanish shares traded on PFOF venues are worse than those executed on the primary exchange. The studies don’t explore the costs that would have been incurred by brokers for accessing multiple venues.

Both sides claim further analysis they are undertaking supports their original findings. But without a single study that acts as a cast iron authority, legislators will find themselves in a quandary. Are they seeking to ban a practice that exploits retail investors, or are they potentially throwing away a great chance for those investors to participate in capital markets at very low fees?

Ironically, a consolidated tape would be the way to provide that definitive answer. However, there’s a possibility that Germany will only agree to the tape, or a ban on PFOF – but not both. And its leaked position paper suggests, if pushed to make a trade-off, the German government will be more flexible on a tape than on a PFOF ban.

Some may argue separating the two makes sense: first, get the consolidated tape up and running, and then use the resulting data to analyse PFOF.

But the trouble is, if the payments become more entrenched during that time, and if more neo-brokers receiving them spring up across the EU, then that could make it even harder to abolish PFOF if the tape proves, after all, that the practice is hurting retail investors.

For the European opponents of PFOF, the time for a ban might be now or never.

Editing by Philip Alexander