This is a long read. There’s a summary at the bottom, but I hope you enjoy the ride as it took most of my Saturday (what else am I supposed to do in lockdown ).
The article Adam linked, We’re nothing like Robinhood, says Berlin-based broker Trade Republic, says that “when asked whether he believes this process — known as payment for order flow — to be ethical, Hecker preferred not to comment”. Christian Hecker is a cofounder and CEO of Trade Republic and made the following comment to Sifted.
“I can only say that the challenge in brokerage in the US is completely different than in Europe. Trade Republic doesn’t cooperate with any hedge fund, we’re not affiliated with anyone, and we have no shareholders.”
You could read this as him saying they don’t accept payment for order flow (PFOF), but he’s not actually saying that. Not literally anyway. So is he obfuscating or concealing the truth?
A quick search finds returns the article above, as well as a blog post from Johan Brenner who is a General Partner of investment firm Creandum. In the blog post, Backing Trade Republic — Commission free trading for everyone, Johan has the following to say about Creandum’s choice to invest in Trade Republic.
Trade Republic, like most online brokers, secures revenues through payment of order flow from trading partners. The major difference is that Trade Republic is willing to share these revenues directly with their customers, enabled through their lean and mostly automated backend/cost structure, and therefore allowing customers to trade commission free.
Even though I’d expect him to know, I’d rather hear it from Trade Republic themselves.
Trade Republic’s home page contains answers to nine questions. The question “How does commission-free trading work?” is answered as follows.
In the past four years we have built a powerful digital bank using modern technology. Like many other brokers, we receive rebates from trading partners. On this basis, we can free you from high order commissions through our efficient structures. There is only a lump-sum fee of one euro per trading transaction for processing.
Aside: The French version of their website links to the German customer agreement. I wonder how non-German-speaking French customers know what they’re agreeing to?
I used Google Translate to translate the customer agreement (it can translate documents as well as text). Annex 1.2 is titled (translated) “Dealing with Conflicts of Interest” and contains the following (translated).
Trade Republic also receives payments from third parties for the execution of the securities orders (see section 4.2. Of the framework agreement). The receipt of these payments and benefits or other incentives serves to make provision and further development more efficient and high-quality infrastructures (ie in particular the application) for the acquisition, observation and sale of a wide range of financial instruments for the customer. Trade Republic publishes the receipt of the benefits to the customer annually.
The wording is a bit unclear. It may just be the translation, but let’s look further. It specifically references section 4.2 as having more details. That section is long and poorly formatted, but it’s all interesting.
In connection with the execution of securities transactions, Trade Republic can make payments from the operators of the execution venues or counterparties for execution transactions (hereinafter " execution venues") or of providers of securities piers (e.g. providers of ETFs; hereinafter referred to as " providers ") for placing orders at these execution venues or Counterparties (ie the execution of commission business) or for the acquisition of certain products from a provider Receive Trade Republic customers. These payments, for example so-called processing cost subsidies, usually amount to up to EUR 3.00 per customer order; in exceptional cases and depending on certain trading volumes up to EUR 17.60 per Customer order (as of 10/2019) (ie Trade Republic can accept a payment up to this amount for placing a customer order the place of execution or from the respective provider). The amount of the payments depends on the individual case agreement with the execution venue or provider and the overall agreement on the execution venue in defined time segments processed turnover. This payment is acceptable. Trade Republic uses payment to give customers the most cost effective and to offer high-quality technical services under this contract. The customer agrees that Trade Republic collects and is allowed to keep these payments. The customer and Trade Republic meet those of the legal Regulation of the right of agency (§§ 675, 667 BGB, 384 HGB) deviating agreement that a claim of Customers against Trade Republic on surrender of the payments does not arise. Without this agreement, Trade Republic would - subject to the applicability of the right of agency to the services of Trade Republic under this contract - issue the payments to the customer.
I’m not a lawyer, but this appears to be where the customer agrees that Trade Republic being paid between €3.00 to €17.60 by “operators of the execution venues or counterparties” for executing their orders with that execution venue or provider. The customer agrees Trade Republic is allowed to keep the payments to use to give customers the most cost effective and high quality services. Interestingly, it specifically says that if the agreement didn’t exist, Trade Republic would issue the payment to the customer.
So yes, Trade Republic’s CEO is obfuscating and concealing the truth. They just never call it ‘payment for orderflow’ and they always try to justify it by linking it to providing their service. If only there was another business model that didn’t involve conflicts of interest.
Speaking of which, Freetrade’s Conflicts of Interest policy, which is directly linked from the website’s footer, explicitly states the following.
We do not receive financial or non-financial benefit from any trade execution venues or counterparties in return for sending our customers’ orders to them (sometimes known as ‘payment for order flow’).
Is Trade Republic’s PFOF legal?
Again, I’m not a lawyer, but I had a look anyway.
Even though Trade Republic is in Germany, I’m starting in the UK. In December 2017, the FCA published an open letter regarding Payment for Order Flow (PFOF). They seem to do this regularly and address the letters “Dear CEO”. In short, this letter restates that “PFOF arrangements introduce a conflict of interest which is likely to cause harm to clients and markets”. It then goes on the talk about MiFID II, which is a revision of MiFID (“Markets in Financial Instruments Directive”). The FCA states that MiFID II “further restricts the practice of PFOF” and “strengthens the conflicts of interest requirements”.
The third and final section of the letter contains three examples of where companies could be trying to avoid MiFID II’s requirements. Here’s the first example:
Linking charges to market makers for non-execution services, such as research products or market analysis software, to the amount of business transacted, in an attempt to replicate the PFOF previously received, or insisting that market makers subscribe to such non-essential services to continue to see the broker’s flow.
Of course, the FCA doesn’t regulate Trade Republic, so we need to look further. At least now we know MiFID II is what should be preventing PFOF.
Does MiFID II affect Trade Republic?
EU directives like MiFID (2002/92/EC) and MiFID II (2014/65/EU) are legislative acts that sets out a goal that all EU countries must achieve. However, it is up to the individual countries to devise their own laws on how to reach these goals. The EU provides a website where you can view all the directives and their national transposition details and dates. For MiFID II, that can be found here where it says Germany published their relevant law on 24/06/2017. It usually says if a directive is only partially implemented, which it doesn’t this time, so German companies like Trade Republic should effectively be regulated by MiFID II.
What does MiFID II actually say about PFOF?
You can find the whole directive here. Of particular interest Article 27, “Obligation to execute orders on terms most favourable to the client”. The whole article is worth reading, but paragraph 2 says the following.
An investment firm shall not receive any remuneration, discount or non-monetary benefit for routing client orders to a particular trading venue or execution venue which would infringe the requirements on conflicts of interest or inducements set out in paragraph 1 of this Article and Article 16(3) and Articles 23 and 24.
This paragraph references Article 23, which is important because it says that if the broker can’t remove conflicts of interest, they must disclose them to the customer. This is probably why the Trade Republic customer agreement discloses this conflict and says the customer agrees to it.
In my intepretation, MiFID II clearly tries to prevent payment for order flow, but doesn’t ban it. Instead, it seems to be allowed as long as it’s disclosed to the customer and the customer agrees to it (even if it’s in a language they can’t read, I guess).
Are Trade Republic not abiding by MiFID II?
I don’t know. I’m not a lawyer. It seems like they are because they’re disclosing the conflict in their customer agreement. However, it’s not MiFID II they need to follow. Instead, they need to follow Germany’s national transposition of the law (i.e. Germany’s laws that implement EU directive 2014/65/EU, aka MiFID II.
I saw someone claim that Germany has an exception, or that PFOF is legal in Germany.
What do Germany’s laws say?
Going back to the national transposition page it says Germany’s relevant laws were published in “Bundesgesetzblatt Teil 1 ( BGB 1 ) ; Number: 39 ; Publication date: 2017-06-24 ; Page: 01693-01821”. This is the Federal Law Gazette, and we’re looking for pages 1693-1821 of issue number 39 of Part 1. They’re all available online for free dating back to 1949, so it was easy to find here. Of course, it’s in German, so I punished Google Translate by asking it to translate the almost 200 pages.
This gazette appears to contain changes to laws. What a thrilling read. Luckily I can just search for “remuneration” and find interesting things. Specifically on page 1744 I found:
§ 33a is amended to § 82 and as follows:
e) Paragraph 8 is worded as follows:
“(8) An investment services company both for the execution of customer orders at a specific trading place or place of execution as well as for the Forwarding customer orders to one specific trading venue or execution place neither a remuneration nor a discount or accept a non-monetary benefit, if this is a violation of the requirements according to § 63 paragraphs 1 to 7 and 9, § 64 Paragraphs 1 and 5, Sections 70, 80, paragraph 1, sentence 2 Number 2, paragraphs 9 to 11 or paragraphs 1 to 4 would represent.”
The translation seems poor, but the wording is really similar to Article 27 of the directive. The above comes from Article 3 “Further amendments to the Securities Trading Act”. In German, Securities Trading Act is Wertpapierhandelsgesetz. What a fun language.
The Wertpapierhandelsgesetz is from BaFin, the “Federal Financial Supervisory Authority”. Thankfully, they publish the Securities Trading Act in English: BaFin - Acts - Securities Trading Act.
Looking back, we saw that “§ 33a is amended to § 82” which apparently means “section 33a was changed and also renamed to be section 82”. It doesn’t appear to have been renamed after as Section 82 is Best execution of client orders.
Paragraph 8, now in English straight from BaFin, states:
(8) An investment services enterprise may not receive any remuneration, discount or non-monetary inducement either for executing client orders on a particular trading venue or for routing client orders to a particular trading or execution venue that would infringe the requirements under section 63 (1) to (7) and (9), section 64 (1) and (5), sections 70, 80 (1) sentence 2 number 2, subsections (9) to (11) or subsections (1) to (4).
That’s the same as the directive, but has a lot more references. Section 70 covers “inducements and fees”. An inducement is what it sounds like: “a thing that persuades or leads someone to do something”. For example, a payment for order flow. This section says:
(1) 1An investment services enterprise may not, in relation to the provision of an investment services or ancillary investment services, accept any inducements from third parties or provide any inducements to third parties that are not clients of this service or do not act on behalf of the client, unless
- the inducement is designed to enhance the quality of the service to the client and does not impair the proper provision of the service in the best interest of the client within the meaning of section 63 (1), and
- the existence, nature and amount of the inducement or, where the amount cannot be ascertained, the method of calculating that amount, is clearly disclosed to the client in a manner that is comprehensive, accurate and understandable, prior to the provision of the investment service or ancillary investment service.
There’s the answer as to why Trade Republic always say their PFOF is intended to improve their service; German law says that’s the only reason they’re allowed to accept the payment. It’s also the reason it’s disclosed in such detail (i.e. the amounts).
Section 70 goes on the say “Investment services enterprises must hold evidence that all inducements paid or received by them are designed to enhance the quality of the relevant service to the client” which would be interesting to see. To me, this seems like a fairly easy loophole to make use of.
What? Can you summarise?
- MiFID II bans unless you disclose it to the customer.
- Germany’s Securities Trading Act (which transposes MiFID II into German law) bans PFOF unless you:
- Disclose it to the customer (including the amount, or calculation & subsequent report), and
- The payments go toward improving the service for the customer (which you must show on request).
- Trade Republic seem to be following the law.
PFOF is clearly a conflict of interest. MiFID II, German law, @adam, @Viktor, and the FCA says so too. The fact the Trade Republic CEO doesn’t comment on whether it’s ethical is telling. The fact he goes on to make it sound like they don’t take PFOF is misleading.
I for one am looking forward to Freetrade’s launch in Germany and France.