The Financial Industry Regulatory Authority (FINRA) has recently unveiled a series of proposed changes aimed at tightening restrictions on payment for order flow (PFOF) arrangements. PFOF is a practice where brokers receive compensation from market makers or other third parties for routing customer orders to specific trading venues. Although this practice is legal under certain disclosures, critics argue that it may create conflicts of interest that ultimately harm retail investors.

 

Background and Rising Concerns

 

In the past few years, zero-commission trading platforms have proliferated, attracting millions of new retail investors into the stock market and related securities. While these platforms tout “free trading,” they often rely on PFOF agreements to cover costs—making it a lucrative revenue stream. However, investor advocacy groups have questioned whether these deals lead to suboptimal trade executions, effectively costing retail traders more through wider bid-ask spreads.

 

A recent FINRA study highlighted that many retail investors are not fully aware of how PFOF might affect the execution quality of their trades. The lack of consistent transparency has become a focal point for regulators, who are now looking at how best to ensure fair and honest treatment for smaller investors.

 

Key Points of the Proposal

 

1. Higher Disclosure Requirements
   Under the proposed rules, brokers would need to disclose PFOF arrangements in a more standardized and detailed manner. This would include specifying how much revenue they earn from different market makers and how that income could potentially impact trade execution quality.

2. Independent Best Execution Review
   FINRA is also considering mandating an independent third-party review of brokers’ order routing practices. This requirement aims to verify whether brokers are genuinely seeking the best execution for client trades, rather than simply funneling them to the venue that pays the highest PFOF.

3. Limiting PFOF on Certain Securities
   One of the more contentious elements of the proposal involves restricting or outright banning PFOF agreements for certain high-volatility securities or complex derivatives. By doing so, FINRA hopes to mitigate scenarios where brokers have significant financial incentives to route orders in ways that may not align with clients’ best interests.

 

Industry Reaction

 

• Brokerage Firms
  Some major brokerage firms express caution, noting that eliminating or severely restricting PFOF could undermine the zero-commission model, forcing firms to reintroduce direct trading fees. This could make the barrier to entry higher for novice traders.

• Investor Advocates
  Consumer protection groups such as the North American Securities Administrators Association (NASAA) and Better Markets have publicly applauded the proposals, citing long-held concerns that the PFOF model disproportionately impacts small retail investors.

 

Next Steps

 

FINRA has opened a 60-day public comment period for interested parties to weigh in on the proposals. After reviewing feedback, the regulator may adjust its language before submitting the final version to the Securities and Exchange Commission (SEC) for approval. If enacted, these rules could go into effect by late 2025, potentially reshaping the commission-based landscape of retail trading.