A proposed Rule by the SEC has some interesting things to say about PFOF;
The SEC makes various claims on how PFOF can lead to worse execution;
Study finds; PFOF receive worse execution quality than non-PFOF
AND, PFOF results in worse execution quality for both Equities and Options based on the SEC citing studies.
With all else equal, internalized orders result in execution quality decline as the amount of PFOF increases. Greater PFOF results in Higher E/Q ratios and Effective Spreads and Less price improvement.
And because of larger spreads, or larger effective spreads, the price improvement isn’t so improved;
All around a bad deal for traders that use Brokers who rely or use PFOF.
The same table indicates wholesalers provide worse execution to Broker-dealers depending on the impact of the Customer’s trades. The Adverse Selection Risk.
So a discussion of ‘Adverse Selection Risk’.
That word gets thrown a bit in the SEC document, ‘Adverse selection risk’.
What that means is the impactfulness, boil it down to volume, of the trade. Higher the impact, higher adverse selection risk. The ability to impact price.
Those traders who can impact price more are less likely to be internalized and less likely to get that ‘price improvement’.
For the Market Maker, adverse selection risk is a -well- risk. So for their underwriting purposes, they want less risk. Duh. So they focus on interacting with order flow in a way to minimize their risk, meaning lower adverse selection risk.
Which means the Market Makers and Liquidity Providers are incentivized to deal with individual investors and retail traders. The ones with low adverse selection risk.
Resulting in PFOF and wholesalers targeting lower adverse selection risk participants.
Which means Retail is being more targeted in getting their trades internalized in the PFOF scheme. It’s simple risk assessment or cost-analysis.
Which may be a good thing if the retail or individual trader gets a price improvement, but the first half of this article points to evidence that suggests that worse execution is happening and PFOF results in a price UN-improvement.
So Retail traders are being targeted with PFOF more and are receiving worse execution and a price Un-improvement.
Say it with me, Brokers are not your Friends.
Everything said here is more technical and backed up by studies used by the SEC. It’s fairly credible in that sense.
The point is, everything above I’ve already mentioned in plain speak on my discussion of PFOF.
PFOF is essentially a juggling act resulting in Retail traders being swindled without them really knowing it. And judging by the newfound information above in the studies, that includes individual investors. Which implies small firms and independent financial firms. So even the small money millionaires might be adversely affected in their order routing process. They too, might be swindled.
Yea, you might be getting a price improvement, but it’s only an improvement from a worse price offered. It’s like a board game where you can move two spaces forward, as long as you start six spaces behind. Yea, sure you’re improving your position. But that’s semantics and you’re actually worse off.
So Brokers who use PFOF are definitely not your friends. Even without discussing PFOF, you can safely say;
Brokers aren’t your friends
*Not Valid Financial, Legal, Life, or Any Advice