Payment for order flow (PFOF) is a controversial practice in the financial and crypto industry. It involves brokers receiving payment from market makers for directing customer orders to them.
What is PFOF?
Payment for order flow is a practice in which a broker or dealer receives payment from a third party for directing order flow regarding the trading of securities and other financial instruments to them for execution. This practice has become increasingly common in many markets around the world, including Germany.
PFOF subject to regulation in Germany
However, payment for order flow is subject to various regulatory requirements and restrictions under German law. The specific legal framework for payment for order flow in Germany is primarily governed by the German Securities Trading Act (Wertpapierhandelsgesetz, WpHG), which implements the requirements of the European Union’s Markets in Financial Instruments Directive (MiFID) in Germany.
Strict requirements for brokers
Under these laws, payment for order flow is generally permissible, but subject to strict disclosure and transparency requirements. In particular, brokers and dealers must provide their clients with clear and comprehensive information about any payment for order flow arrangements they have in place. This includes disclosing the nature and extent of any payments received, as well as any conflicts of interest that may arise as a result of these arrangements.
In addition, brokers and dealers must take steps to ensure that payment for order flow arrangements do not compromise their duty to act in the best interests of their clients. This includes implementing appropriate internal controls and procedures to manage any conflicts of interest, and taking steps to ensure that their clients receive best execution on their orders.
Moreover, brokers and dealers must comply with strict record-keeping requirements. This includes maintaining detailed records of any payment for order flow arrangements, as well as records of all orders executed on behalf of their clients.
Regulator’s concerns about payment for order flow
Regulators have expressed concerns about payment for order flow and may consider banning or limiting the practice to protect customers and promote fair and transparent markets.
Banks and crypto service providers may be incentivized to prioritize directing orders to market makers that offer the highest payments, rather than those that offer the best execution quality for customers. This can potentially harm customers by leading to inferior prices or execution quality and could erode trust in the financial system.
As a result, banks and crypto service providers may need to evaluate the risks and benefits of continuing to engage in payment for order flow and explore alternative business models to ensure they are acting in the best interests of their customers.
PFOF generates high profits
Payment for order flow is a significant source of revenue for crypto-asset service providers (CASP), particularly those that facilitate high-volume trading activity. According to a report by the U.S. Securities and Exchange Commission (SEC), payment for order flow in the context of securities and other financial instruments trading can account for a significant portion of broker-dealer revenue, with some firms generating tens or even hundreds of millions of dollars in annual revenue from this practice.
While there is limited data available on the specific amount of profit that CASP make from payment for order flow, this practice is a significant source of revenue in the cryptocurrency industry. The amount of profit that crypto service providers make from payment for order flow can vary widely depending on a number of factors, including
- the volume and type of orders being executed,
- the size and frequency of payments received from third parties, and
- the costs associated with operating the platform.
PFOF and crypto services
In the context of crypto services, payment for order flow refers to the practice of a crypto exchange or other service provider receiving payment from a third party for directing order flow to that party for execution. Cryptocurrencies are not currently subject to the regulatory framework of the WpHG, as they generally do not fall under any of the categories of Section 2 WpHG, and, thus, not under the scope of the WpHG. Therefore, the rules regarding payment for order flow in the context of cryptocurrencies are not specifically governed by the WpHG.
Crypto assets are financial instruments
However, as crypto assets qualify as financial instruments according to section 1 paragraph 11 Sentence 4 of the German Banking Act (Kreditwesengesetz, KWG), and custody and brokerage of such qualify as banking and financial services, the general rules for banks and financial service providers of the KWG apply. While the KWG does not specifically regulate payment for order flow, it regulates financial services in Germany, including the provision of banking, investment, and other financial services.
As a result, payment for order flow in the context of cryptocurrencies is subject to the general rules and principles governing financial services under the KWG. This includes the duty of financial service providers to act in the best interests of their clients and to disclose any conflicts of interest, as well as record-keeping and transparency requirements.
Markets in Crypto Assets Regulation
The Markets in Crypto Assets Regulation (MiCAR) is a proposed regulatory framework for crypto assets in the European Union. It aims to establish a comprehensive regulatory regime for the issuance, trading, and custody of crypto assets, with the goal of protecting investors and promoting market integrity.
MiCAR would require crypto asset service providers to obtain authorization from their home country’s financial regulator and would impose a range of prudential and conduct requirements on these providers.
Prohibition of PFOF for crypto asset service providers
Art. 72 paragraph 2 MiCAR states that crypto asset service providers that are authorized for the provision of the reception and transmission of orders on behalf of third parties shall not receive any remuneration, discount or non-monetary benefit for routing clients’ orders to a particular trading platform for crypto assets or to another crypto asset service provider.
Therefore, crypto asset service providers must not engage in payment for order flow practices and must ensure that they comply with the prohibition in Art. 72 paragraph 2 of MiCAR. Providers must also take appropriate measures to manage any conflicts of interest that may arise in the course of providing their services, in order to fulfill their obligation to act in the best interests of their clients.
This prohibition is in line with the general regulatory approach in the EU to restrict payment for order flow practices, which are seen as potentially creating conflicts of interest and, in the eyes of the European Securities and Markets Authority (ESMA), undermine market transparency and fairness.
Legal advice on PFOF
Payment for order flow is a controversial practice in the financial and crypto industry, and there is a possibility that it may be prohibited in the future. If such a prohibition were to occur, there may be smart ways to legally work around it. WINHELLER can advise your organization on issues relating to payment for order flow and other kickbacks.
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