MiFID II's Approach to Inducements
MiFID II treats PFOF as an 'inducement' — a payment from a third party that creates a conflict of interest for investment firms. Under MiFID II, investment firms are generally prohibited from accepting inducements that are not designed to enhance the quality of service to clients. PFOF fails this test in most cases because it compensates brokers for routing rather than for providing better execution quality.
Practical Effect in European Markets
In European markets subject to MiFID II, retail equity order routing generally does not involve PFOF in the form practiced in the United States. Brokers must demonstrate that any third-party payments they receive are justified by service quality enhancements for clients. This has led to different competitive dynamics in European equity markets.
European Market Quality Outcomes
Studies of European market quality after MiFID II implementation have examined whether the restriction of PFOF improved execution quality for retail investors. The evidence is mixed, with some studies suggesting modest improvements in certain metrics and others finding limited impact. This debate is relevant to U.S. policy: proponents of PFOF reform cite European data; PFOF defenders challenge its applicability.
Implications for U.S. Policy
The experience of EU and UK markets with stricter PFOF restrictions provides empirical evidence that developed financial markets can function without PFOF as practiced in the United States. Whether U.S. regulators will draw lessons from European experience depends in part on the regulatory and political environment — including the lobbying and political spending of major PFOF-dependent firms.