The Council’s position on Payment For Order Flow, a territorial approach instead of the Capital Markets Union – How did we get here, what is the way out? - MAY 2023

This Debate paper was drafted under the responsibility of Robert Ophèle, President of the Advisory Committee for Debate Papers of the AEFR.

This Debate Paper investigates a paradox: as part of the MiFIR review, a file that is instrumental to the building of the long-awaited Capital Market Union, one of the compromises explored to bridge a contentious issue (to curb or not to curb the practice of “payment for order flow”, or PFOF), is a territorial option that is in direct contradiction with the principles of the Single Market.  The opt-out solution proposed – individual Member States could lift the ban on PFOF for intermediaries licensed in their jurisdiction, but only for their resident clients – is an unprecedented configuration, essentially negating freedom to provide services across the Union, a pillar of the Single Market.

Before analysing the risks entailed by the territorial option for PFOF, this Debate Paper dwells on the reasons that explain how it came to that.  It appears that it is a mixture of:

• a contentious file, on which Member States positions are orthogonal – which as such is not an unprecedented situation in a level 1 negotiation for financial services, especially MiFIR where different actors in the “order to venue” value chain have naturally opposed interests, and

• a growing frustration from Host countries in the context of the swift rise of neobrokers and subsequent “platformisation” of retail investment, whereas all the while a common regulatory and enforcement vision between supervisors could not be delivered by ESMA

In doing so, this paper digs into the underlying case for and against a PFOF, presenting its intrinsic flaws, to explain why it has generated such heated disagreements. In doing so, it does not reflect a consensual view on PFOF, which as mentioned above does not exist, nor does it pretend to represent all aspects of the case. Rather it articulates the necessity to preserve a pan-european framework if one truly wants to trigger a Capital Markets Union.

As a disclaimer, when addressing these issues, the paper focuses (i) on retail trades flows, as opposed to institutional flows, and (ii) on market structure and practices for cash equity stocks and ETFs, leaving aside listed derivatives (warrants, options, turbos). Apart from the angle of the “PFOF-backed privatisation” of retail flows, the paper refrains from entering the debate on competition between transparent and dark trading venues, apart from advocating for a sound basis for competition, which is not the case with the current practice of PFOF in the EU, and certainly will not be resolved by the compromise proposed by the Council, that avoids tackling the substantive issue and does not ensure a level playing field.

All European players have something to lose from the infringement of the principles of the Single Market, and failure to resist such a flawed compromise would set a precedent detrimental to pan European market operators, be them trading venues, market makers and brokers, notwithstanding the retail investor community.

While this issue is currently being debated in the trilogue between the co-legislators, it will without doubt rebound, both on perimeter – the EU Parliament has expressed strong doubts about the wisdom of the territorial option – and on substance, as proposals to define a common framework for PFOF have emerged, so far to no avail. They in turn raise important unresolved questions as to the conditions and definition of best execution, which are not discussed here, as they would warrant their own debate paper. Meanwhile, the recent draft of the Retail Investment Strategy of the EU Commission that was recently leaked will prolong the show, as it proposes to ban inducements paid to distributors for execution-only sales, where no advice relationship between the investment firm and the client exists: a situation that covers orders executions by definition and would thus… ban PFOF.

The paper ends with proposals to get out on top, which are easy to champion but more difficult to enforce: tackle the substantive issues by resolving the debate with a harmonised position – the ban being the preferred choice, as it is supported by a large majority – and advance on common supervision across capital markets, which would facilitate such a resolve by keeping entrenched positions at bay. A difficult task but a necessary one, otherwise trust in EU cross-border investment will eventually fade and the CMU will be doomed to fail.