As the financial industry digests the SEC's long-awaited decision on Payment-for-Order-Flow – and Netflix's treatment of the GameStop saga that brought about the intense scrutiny of the controversial policy - we spoke to the CEO of a professional trading firm with an unusual degree of familiarity with the world of financial regulation.

Daniel Schlaepfer
Daniel Schlaepfer Daniel Schlaepfer

The subject of day trading has never featured more heavily in international news headlines than it has in the past two years. In January 2021, when retail traders conspired on Reddit to send GameStop stocks through the roof, and some hedge funds crashing into the ground in the process, there was no other story on Wall Street. The chaos those days engendered in the financial markets and the big questions that subsequently arose about the nature and practice of stock trading is now the subject of a Netflix documentary 'Eat the Rich: The GameStop Saga'.

After Robinhood chose to restrict trading on the stocks involved, financial news turned at once into political controversy, cultural stand-off and social media pantomime, as such disparate figures as Alexandria Ocasio-Cortez and Elon Musk weighed into the debate on Twitter and ClubHouse. For a brief period, day trading was the biggest story on earth.

On 18th October 2021, the SEC released a long-awaited report into the GameStop saga, led by chair Gary Gensler. The 44-page report was set to have implications for brokerages, wholesale market makers, exchanges and retail investors like. Amongst the topics it addressed were the so-called 'gamification of trading' by commission-free retail brokerages, which Gensler said was a growing concern because it could encourage more trading than is in investors' best interests.

At the heart of the report was the practice of 'Payment for Order Flow' (PFOF), largely responsible for giving rise to the commission-free trading apps which have allowed trading by retail investors to continue boom, and which Gensler had hinted he was considering banning outright. The report stopped short of doing so, and after almost a year of further deliberations, on 22nd September 2022 the SEC confirmed it would not be banning the practice, and instead proposed new rules for the $48 trillion American equities market.

Payment for order flow (PFOF) enables brokerages like Robinhood to sell customers' buy and sell orders to wholesalers, such as Citadel. This allows the firms to generate revenue without charging commissions for trades. But the reality is that brokers are offering zero-commission trading to retail investors when commissions are in fact are being subsidized by wholesalers.

For Daniel Schlaepfer, the CEO of Select Vantage Inc (SVI), a proprietary trading firm engaging professionally trained day traders, the decision is disappointing, having long argued that banning PFOF would strike at the heart of the 'gamification' problem. "For many of us in the trading industry, a frank discussion about PFOF felt long overdue", says Schlaepfer, whose firm requires its traders to undertake intensive training and comply with rigorous loss restrictions in order to trade to firm's capital.

"Quite simply, the reliance on PFOF to surreptitiously finance the illusion of free trading requires examination. When something is free, human nature tends to undervalue it. What many retail investors appear to have failed to realize is that free trading is possible only because they themselves have become the product."

Schlaepfer says that to see why requires an understanding of the origins of the practice. "Decades ago, old-fashioned floor traders demanded that a one cent spread be mandated to cover their risks in providing market-making services. But today's markets mostly use computers to provide liquidity on over 80% of the daily trading volumes."

In his view, PFOF continues to flourish because regulators have mandated that trading occur at minimum trading increments that are substantially wider than markets now require. In a perfect world, he says, bids and offers would be at the same price, with only access costs to consider.

For Schlaepfer, removing PFOF is about letting market incentives resolve market problems, giving investors access to the better pricing of a perfect market. "Access fees would become transparent and so properly factored into trading decisions, and the fact of incurring this cost would likely deter small retail investors from indulging in risky gamification, so a more sustainable equilibrium might be reached in the long-term."

But PFOF was not the only aspect of Gensler's original report which Schlaepfer was looking out for. In his view, more pressing than the hidden costs of retail trading are the hidden costs of financial regulation itself. He has argued that the costs of compliance have risen so much since heavy-handed regulations were introduced after the financial crisis – from Dodd-Frank in the United States to MiFID II in Europe – that only established market participants can afford to implement them. In his words, regulations designed to force "too big to fail" firms to toe the line have had the effect of consolidating the status quo, and made many smaller firms "too small to comply".

"If you had to characterize the key trends of financial regulation in the last twelve years, you would say it has become more complicated, and more expensive", says Schlaepfer, "smaller firms are being priced out of the market because they can't afford to keep up – these days you need a huge compliance team just to meet the bare minimum. We were hoping the SEC report might address this, but it didn't – and that's a problem."

Schlaepfer's firm is not small – SVI engages over 2,500 traders in 264 offices in 39 countries around the world – but the need to supervise so many traders is not cheap. He has also incurred significant legal costs in disputes with financial regulators. Most notably, he recently emerged the moral victor from a 5 year legal battle with the Australian Securities and Investments Commission (ASIC), which he had been suing for defamation since 2016, alleging the regulator's head of market supervision had spread "unsubstantiated hearsay" about his firm to brokers, causing them to discontinue business with SVI.

Though ASIC succeeded in establishing the defense of qualified privilege, the judge stated that Schlaepfer had been "successful on most issues including the defense of truth. That success has achieved what was said to be an important outcome of the appeal, namely, the vindication of Mr. Schlaepfer's reputation."

"Suing powerful regulators for inappropriate conduct is not an endeavor one enters into lightly" Schlaepfer said after the case, "we felt forced to do so in light of what we perceived to be unfair behavior by ASIC."

At the end of the day, he is eager to strike a conciliatory note, however. Schlaepfer – who is based in Toronto – sits on the Ontario Securities Commission's 'Market Structure Advisory Committee (MSAC)', designed to promote dialogue and understanding between regulators and market participants.

"Sometimes the concerns of regulators are simply misunderstandings – these issues should be raised with firms directly, who should then be provided with the opportunity to explain their behavior", he says.

Whether the SEC's long-awaited decision - or Netflix's new documentary - will foster greater understanding between industry participants remains anyone's guess. Either way, it's never been a more relevant time to be a trader.