Can the Proposer-Builder Separation Model from Blockchains Be Applied to Traditional Financial Markets?

Concept

The inquiry into whether the Proposer-Builder Separation (PBS) model from blockchains can be applied to traditional financial markets is an examination of systemic architecture. At its core, this is a question about the division of labor, the management of incentives, and the mitigation of value extraction that is inherent in any system where transactions are ordered and executed. The architecture of a market dictates the flow of information and capital, and in doing so, it defines the opportunities for profit and the points of potential conflict.

In the blockchain ecosystem, particularly Ethereum, Proposer-Builder Separation was conceived as a surgical intervention to address the centralizing pressures of Maximal Extractable Value (MEV). Before the formalization of this model, the entity responsible for validating a block of transactions (the proposer) was also responsible for constructing it. This dual role created a powerful incentive for validators to invest in sophisticated infrastructure to sequence transactions in a way that maximized their own profit, a process that could lead to network centralization and potential censorship.

PBS dismantles this monolithic role. It establishes two distinct, specialized functions ▴ the builder and the proposer.

Builders are specialists in a high-stakes optimization game. They ingest a vast pool of pending transactions and use complex algorithms to assemble the most profitable block possible. Their output is a complete, ordered block of transactions, along with a bid representing how much they are willing to pay the proposer for its inclusion in the blockchain. The proposer’s role is simplified.

They no longer need to engage in the complex and resource-intensive task of block construction. Instead, their function is to survey the bids from various builders and select the most profitable, valid block header to propose to the network for final validation. This separation allows for specialization, theoretically enhancing network security and decentralization by lowering the resource requirements for validators.

This division of labor isolates the complex, resource-intensive task of transaction ordering from the core consensus function of transaction validation.

This fundamental principle of role separation is not foreign to traditional financial markets. A direct architectural parallel exists in the structure of modern equity and options trading, specifically in the relationship between retail brokers, wholesalers, and exchanges. In this system, the retail broker acts as the initial aggregator of orders. The wholesaler, or market maker, functions as the specialized builder.

These firms, such as Citadel Securities or Virtu Financial, purchase the right to execute retail order flow from brokers, a practice known as Payment for Order Flow (PFOF). They then use their own sophisticated trading systems to execute these orders, profiting from the bid-ask spread.

The exchange, in this analogy, represents the final proposer or validator. It is the ultimate venue where trades are officially recorded and settled, operating under a set of established rules like the National Best Bid and Offer (NBBO) to ensure a baseline of execution quality. The broker, by routing orders to a specific wholesaler, is effectively proposing that wholesaler as the builder for that block of transactions.

The core concept is identical to PBS ▴ the entity originating the order is distinct from the specialist entity that optimizes its execution for profit. The application of PBS to traditional markets is therefore less an act of invention and more an exercise in architectural refinement and transparency.

Strategy

Adapting the Proposer-Builder Separation framework to traditional markets requires a strategic analysis of the existing roles, incentive structures, and value extraction mechanisms. The goal is to determine if a more formalized, transparent auction for order flow, akin to the builder bids in PBS, could create a more efficient and equitable market structure than the current, more opaque system of Payment for Order Flow.

A Comparative Analysis of Market Roles

The strategic alignment between the blockchain and traditional finance models becomes clear when the roles are juxtaposed. Each system has actors performing analogous functions, though the terminology and underlying technology differ. The core strategy of separation is to mitigate conflicts of interest and encourage specialization.

What Are the Incentives Driving Each System?

The incentives within each system reveal both the potential benefits and the inherent tensions. In the PBS model, builders are incentivized to create the most valuable blocks to win the auction, which involves sophisticated strategies to extract MEV. Proposers are incentivized to simply choose the highest bid, a clear and unambiguous goal. This structure is designed to keep the proposer’s role simple and the competition among builders fierce, which should, in theory, pass a portion of the extracted value back to the proposer.

In the traditional PFOF system, the incentives are more complex. Wholesalers pay brokers for their order flow, which provides them with a predictable stream of trades from which they can profit via the bid-ask spread. Retail brokers, in turn, are incentivized to route orders to the wholesaler that offers the most attractive PFOF terms, which allows them to offer commission-free trading to their clients. While this has democratized market access, it creates a principal-agent problem.

The broker’s financial incentive (maximizing PFOF revenue) may not perfectly align with the client’s best interest (achieving the best possible execution price). Academic models suggest that PFOF can lead to wider spreads and a net transfer of value from investors to liquidity providers.

The strategic challenge lies in designing a system where the competition to execute orders directly benefits the originator of those orders.

Value Extraction Mechanisms a Tale of Two Markets

Both systems are built around the extraction of value from the flow of transactions. Understanding these mechanisms is key to evaluating the strategic viability of a PBS-like model for traditional finance.

• Maximal Extractable Value (MEV) In the blockchain context, this refers to the profit a builder can make through their ability to arbitrarily include, exclude, or reorder transactions within a block. Common forms include front-running, where a builder sees a large pending trade and places their own order first, and “sandwich attacks,” where they place orders before and after a user’s trade to exploit the resulting price impact.
• Spread Capture and Price Improvement In traditional markets, the primary value for a wholesaler is the bid-ask spread. By handling millions of retail orders, they can consistently buy at the bid and sell at the ask. PFOF is essentially the wholesaler sharing a portion of this captured spread with the broker. Proponents of the system point to “price improvement,” where wholesalers execute retail orders at a price better than the public NBBO, as a benefit. However, critics argue this improvement may be less than what could be achieved in a more competitive, transparent auction environment.

A PBS-style auction in traditional finance would change the strategic landscape. It would force wholesalers to compete for order flow on an order-by-order or block-by-block basis, making the payment for that order flow transparent and directly in the form of price improvement for the end investor. This shifts the competition from opaque, bilateral PFOF arrangements to a public, competitive auction where the winner is determined by who gives the most value back to the investor.

Execution

The execution of a Proposer-Builder Separation model within traditional financial markets is a question of system architecture and protocol design. It involves redesigning the pathway that an order takes from a retail investor to its final execution, replacing the opaque Payment for Order Flow system with a transparent, competitive auction mechanism. This approach is not merely theoretical; it aligns with concrete proposals for order-by-order auctions considered by financial regulators and academics.

The Operational Playbook an Order-By-Order Auction Framework

Implementing a PBS-like system for equities would require a coordinated effort between brokers, exchanges, and wholesale market makers. The process would transform order routing from a series of private arrangements into a public, competitive process.

1. Order Aggregation A retail broker, instead of immediately routing a client’s market order to a pre-determined wholesaler, would aggregate it with other retail orders into a standardized block. This block could be defined by a short time interval (e.g. all market orders received within a 100-millisecond window).
2. Submission to Auction The broker submits this aggregated block to a centralized auction facility, likely operated by a national securities exchange (acting as the “Proposer”). The auction message would contain the anonymized details of the order block.
3. Competitive Bidding by Builders Registered “Builders” (the current wholesalers and other high-frequency trading firms) would have a very short window (e.g. 50-100 milliseconds) to submit a binding bid for the entire block. The bid would be a commitment to execute the entire block at a specified level of price improvement over the prevailing National Best Bid and Offer (NBBO).
4. Winner Determination and Execution The exchange’s auction engine instantly awards the block to the Builder offering the highest price improvement. The winning Builder pays this price improvement directly to the retail clients, and the execution is printed to the consolidated tape. The broker could be compensated via a transparent, fixed auction fee.

Quantitative Modeling and Data Analysis

The primary advantage of this model is that it makes the economics of order execution transparent. The value that wholesalers derive from retail order flow is forced into the open and transformed into a quantifiable benefit for investors. We can model a hypothetical auction for a block of 10,000 shares of a given stock.

In this scenario, the exchange’s auction mechanism would award the block to Builder B. The $17.00 in total price improvement is a direct, measurable benefit to the retail investors in the block, a stark contrast to the current PFOF system where the financial benefit is split opaquely between the broker and the investor. This auction model forces Builders to compete on the metric that matters most to the end client ▴ execution price.

By structuring execution as a competitive auction, the system’s design directly channels the value of order flow back to the investors who create it.

How Would System Integration Be Architected?

The technological lift for such a system is significant but achievable with current financial technology. It represents an evolution of the existing market infrastructure.

• Exchange Architecture Exchanges would need to develop and maintain a high-throughput, low-latency auction engine capable of processing thousands of these mini-auctions per second. This is an extension of the matching engines they already operate.
• Broker and Builder APIs New, standardized API protocols would be required for brokers to submit order blocks and for Builders to submit bids. These protocols would need to be highly efficient and secure, likely based on existing financial information exchange (FIX) standards but optimized for this specific auction purpose.
• Regulatory Framework This system would operate under a revised regulatory framework, likely an evolution of Regulation NMS. Rules would need to be established for auction participation, minimum price improvement increments, and clear reporting standards to ensure transparency and auditability. The goal of the regulation would be to codify the broker’s duty of best execution within the auction’s competitive structure.

By applying the core principle of Proposer-Builder Separation, financial markets could evolve from a system where value is captured in complex, bilateral arrangements to one where value is revealed through open competition. This would be a significant step in aligning the architecture of the market with the interests of its participants.

Reflection

Re-Architecting the Flow of Value

The exploration of Proposer-Builder Separation within the context of established financial markets compels a deeper reflection on the systems we build and the incentives they create. The core takeaway is that market structure is never neutral. It is a deliberate design that allocates advantage, directs capital, and defines the nature of competition. Viewing market problems through an architectural lens ▴ understanding the roles, the pathways, and the protocols ▴ moves the conversation from symptoms to systems.

The current discourse around Payment for Order Flow often centers on fairness. An architectural analysis reframes this. It asks a more fundamental question ▴ Is the current system, with its opaque bilateral arrangements, the most efficient design for channeling the inherent value of retail order flow back to the investors who produce it? The PBS model, in its purest form, suggests that a transparent, competitive auction is a superior architecture for price discovery.

The knowledge gained here is a component in a larger system of institutional intelligence. How might the principles of transparency, specialization, and competitive bidding be applied to other areas of your operational framework to unlock value and mitigate hidden conflicts?