PFOF can P OFF! Transparency is the only way ahead

The early attempts to eliminate conflicts of interest in FX were worth it and now, as the entire electronic trading industry faces a revolution toward people power, we will likely see the result. PFOF can P OFF !

It has been a longstanding moot point at FinanceFeeds as to why brokerages, liquidity providers and clients have become so acquiescent to conflicts of interest that exist within the FX industry.

So ingrained is the lack of interest in revolutionizing the means by which relationships are conducted between all parties involved in trade execution, pricing and market structure that it is occasionally mentioned privately, but that’s about it.

It has taken a tremendous and sudden shift toward placing the policy of financial services into the hands of social media groups, as demonstrated last week by the effect the forum users on Reddit group WallStreetBets had on the entire retail trading market to the extent that many firms intentionally locked their clients out of platforms, exposing their ‘you against me’ methodology as clear as daylight.

FinanceFeeds investigated this in detail, and the grovelling from some of the large retail firms has been monumental, yet they still do not alter their methods.

PFOF is an acronym that is not often mentioned, however it is an instrumental methodology within the OTC derivatives sector that must be paid attention to.

PFOF, which stands for Payment For Order Flow occurs when an investment firm (typically a broker) that sources liquidity and executes orders for its clients receives a fee/commission from both the client that originates the order and the counterparty the trade is then executed with (typically a market maker or other liquidity provider.

These payments create a conflict of interest between the firm and its clients. This is because they incentivise the firm to execute its clients’ orders with counterparties based on their willingness to pay commissions. A broker can make a financial gain at the expense of its clients
and have an interest in a transaction that is contrary to its clients’ interests, which risks inferior execution outcomes and other potential consumer harms.

The Financial Conduct Authority (FCA) in the United Kingdom has been publishing its perspective on this methodology for a long period of time, but does not act on it, and nobody really looks at it.

The dubious practice in which companies whose core business activity is providing services, be they liquidity, brokerage solutions or market integration services to retail FX brokers and then open a retail FX brokerage with an MetaTrader 4 off-the-shelf solution under a different name.

This is a classic case of conflict of interest, as it positions a vendor in direct competition with its own clients, as well as giving them a potential edge over their own clients due to the access to brokerage databases, business models and customer pipeline which could easily be fed to their own retail entity, which under a different name and jurisdiction, would likely go unnoticed by any regulator or unsuspecting brokerage which entrusts its valuable intellectual property with its vendor.

Questionable conflicts between firms and clients have been de rigeur over the years, and whilst regulatory officials make very scant attempts to curtail it, once again it is the astute among the executives within the electronic trading industry who will put this to an end and bring full transparency to us all.

With the inevitable demise of the reputation of Robinhood, a hype that was built upon a formula of marketing over substance, it is clear that, along with the industry efforts to put as top to PFOF, the absolute pitfalls are now glaringly obvious.

There is to be no more ‘gamification’ or trendy but ridiculous attempts by affiliate marketers and gaming companies to try to assimilate FX and CFD brokerages into that category. As FinanceFeeds said last week, affiliate lead churning, b-booking novice clients in third tier regions with $200 deposits in a ‘you against me’ fashion and appearing to behave in the same way that gaming firms do is NOT financial services.

FX and CFD trading is financial services, and the only way to continue in a sustainable fashion is by using proper liquidity from proper markets and embracing the multi-asset method that derivatives traders are used to in genuine global markets.

Outages because a broker decides to save itself against the customers that it is trading against do not occur within platforms that attach to the vast exchanges of Chicago, Singapore and Sydney. They do not occur when executing trades via the prime brokerage division of Tier 1 banks, or via large institutional non-bank networks.

PFOF is quite simply dead in the water, and now there are firms actively operating new models to ensure that this new democratized way forward keeps its momentum.

Whether this is a reactive move to gain favor or not, Public, which is a trading application in the same respect that Robinhood is, has dropped PFOF in favor of tips.

Public, like Robinhood, is a zero-cost trading service and may also be written off as a trendy upstart, however with established firms such as IG Group showing its hand this week, perhaps new blood is what is needed, as long as it disrupts the status quo in a positive manner. Public’s founders have worked to build a community-first platform, including offering ways to let groups chat about their investments.

Robinhood raised a huge amount in new capital at the beginning of February to ensure it has enough cash to meet clearinghouse deposit requirements. It managed to do so in part because its Q4 2020 numbers show that its PFOF business is ticking along nicely.

It is astonishing that venture capital can be so easily obtained when so little due diligence is conducted. MetaTrader brokers cannot list on public exchanges or sell their companies even if they have huge monthly revenues, because an auditor would note that there is no intellectual property as all of the clients are held on MetaQuotes servers, yet those firms have been going for many years and are bastions of marketing and strategic partnership genius with ever increasing revenues. IC Markets, for example, regularly makes revenues of $500 million per month, yet it will never be able to issue an IPO or sell its business. It is a pure affiliate marketing network with over 20 MetaQuotes servers. Churn and turn the handle, but no chance of selling.

It is a far better proposition for an investor than the likes of Robinhood however, yet the cash keeps being poured down the black hole. Clearly due diligence lawyers working for venture capital funds don’t understand that business models based on PFOF related conflicts of interest are dead in the water. If liquidity providers are doing this, it is even more grave.

PFOF makes it more likely that extra costs will be passed on to the broker’s client, through wider bid-ask spreads from market makers and other liquidity providers who agree to pay PFOF to attract order flow from brokers.

While the impact of PFOF may not be visible in bid-askspreads for each transaction, it is likely to affect aggregate spreads as liquidity providers need
to account for the payments made to brokers. These hidden costs make the price formation process less transparent and efficient. They can also distort competition by forcing liquidity providers to use a ‘pay-to-play’ model. Brokers may concentrate order flow to specific liquidity providers, while avoiding others, which may lead to poorer outcomes for clients and reduce market integrity.

FX industry figure Jannick Malling’s Public, flush with a recent $65 million Series C, took a different tack this week and announced it would “stop participating in the practice of Payment for Order Flow.”

Public is not going to sell its order flow to market makers for fees. That’s good for users, but how will it make up the lost revenue? Tips, which will prove an interesting experiment in monetization.

TechCrunch asked the company if it believes tips will compensate for PFOF revenue, to which founders Leif Abraham and Jannick Malling replied via email that they were “optimistic that the difference will be offset by the optional tipping feature.”

Jannick Malling was widely respected in the retail platform sector when he ran the democratized app-based trading platform tradable.

Unfortunately, tradable bit the dust some years ago, but Mr Malling was definitely onto something at that time. Perhaps he had the usual Scandinavian trait of being so advanced and sophisticated that he was ahead of his time.

It has been nigh on impossible for many new firms with API-based platforms to gain any traction over the traditional MetaTrader 4 platform which was initially designed to operate in a closed ‘warehouse’ environment and not to connect to external liquidity feeds from prime brokerages, and has had to be adapted by specialist liquidity management technology and bridge providers in order to operate in today’s retail trading environment.

That in itself was a very significant indicator that MetaTrader 4’s dominance would be set in concrete. When the retail trading firms that do not develop their own platforms switched en masse away from the warehouse model at the beginning of this decade and the entire trading topography began to emulate the institutional world, instead of eschewing MetaTrader and opting for all new, a-book orientated FIX API-connected platforms with novel applications and an opensource developers area for the purpose of designing new trading tools, the vast majority of brokerages remained steadfast in their loyalty to MetaTrader 4 and a whole host of specialist developers began adapting its interface in order to connect it to live liquidity streams.

Tradable, led by the astute, slick and dynamic Jannick Malling is a particular case in point. The platform appeared on the scene just over nine years ago, a bastion of leading edge modernity, oozing ‘new generation’ right the way from the composed classiness of Mr Malling himself right the way through to the execution of the platform’s design. The world’s very first application-based platform, within which users could develop their very own trading applications, and the ability to avoid needing any liquidity bridge, as it connected directly into a broker’s infrastructure and a liquidity provider’s price feed via API, revolutionary in the retail trading platform business at the time.

So why did it fail?

Just like a fine restaurant, with a top quality menu, whose chef provides a fine epicurean experience, painstakingly arranging the smoked salmon carpaccio on translucent plates, lit beneath, with the pickled radish and lemon segments shaped in an arrangement that alludes more to art than cuisine, yet positions the restaurant in an unknown suburb of a small town, the burger and fries of the mainstream will make the larger profit.

Tradable, in that case, is a Danish razor shell with parsley jelly, buttermilk snow and horseradish, served in a top quality marina-side restaurant, whereas MetaTrader 4 is a gourmet burger, with relish in a sachet from an outside catering supplier.

What has become patently apparent over recent months is that Tradable has begun to disappear entirely. Slow takeup and the unfaltering dominance of MetaTrader 4 is one major factor that a developer of any new platform must consider. In the Far East, a massively important region for retail trading, Expert Advisers (EA), which are automatic trading robots are very popular, and MetaTrader 4’s compatibility with the several thousand EAs that are currently available is one reason for its initial rise to absolute dominance.

With such a stranglehold over the entire market, those attempting to reinvent the wheel must do so by not spending a fortune, and by knowing their niche, as well as respecting the massive shadow that the one all-encompassing company – MetaQuotes – casts over everyone else.

Instead of going the route of Spotware Systems with its cTrader and cAlgo solutions, in which Spotware anchored its development by gaining a very large customer – FxPro – in order to be able to have a steady core income whilst evolving products as well as being able to provide customized platforms for brokers that commission the firm to build one for them instead of going to the extent of investing in a proprietary platform, Tradable held itself out as a firm with ambitious new ideologies and attempted bold steps into uncharted waters, and quite right too.

Clearly even at the time when Tradable entered the market almost a decade ago, the trading audience was different. The people on Reddit who form the market via social media today were only 10 years old back then. Children of the 1960s were retail traders and talked about technical analysis and only used forums to find out which Expert Advisor to buy. They put trust in their vendors. Today’s traders are the social media generation who trust nobody and who use forums to form the scope of modern business.

Tradable was the platform that would have served that today and Mr Malling therefore has a good background to put an end to PFOF and hand the alignment back to the clients.

Six years ago, Tradable had been taken up by a handful of brokers and was still in start-up mode. India-focused, UK-based Tradenext was one of the very first firms to adopt the platform, however the volume conducted on Tradable was negligible and Tradenext continued to major on MetaTrader 4, even though Tradable was in its ‘Tesla moment’ of revolutionary wow factor appeal at the time.

Mr. Malling himself appeared to have retreated somewhat, but that was far from reality. He is actually doing what he wanted to achieve with Tradable – democratizing the electronic trading industry.

As far as this can possibly be researched, we estimate that Tradable’s entire expenditure until its demise in 2016 to have been approximately $10 million, leaving its investors to lick their wounds. However, they have all participated in what is now coming to fruition – the full democratization of FX and CFD trading.

The early attempts were worth it and now, as the entire electronic trading industry faces a revolution toward people power, we will likely see the result.

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