Payment for order flow (PFOF) is the practice of retail brokerages routing customer orders to market makers usually for a small fee. Market makers, who are required to deliver the “best execution,” carry out the retail orders, profiting off small differences between what shares were bought and sold for. Retail brokerages, in turn, use the rebates they collect to offer customers lower–or often zero–trading fees.
While widespread and legal, payment for order flow is controversial. Critics argue it poses a conflict of interest by incentivizing brokerages to boost their revenue rather than ensure good prices for customers. The requirement of best execution (by the Securities and Exchange Commission, commonly known as the SEC ) doesn’t necessarily mean “best price” since price, speed and liquidity are among several factors considered when it comes to execution quality.
Defenders of PFOF say that mom-and-pop investors benefit from the practice through enhanced liquidity, the ability to get trades done. They also point to data that shows customers enjoy better prices than they would have on public stock exchanges. But perhaps the biggest gain for retail investors is the commission-free trading that is now a mainstay in today’s equity markets. Here’s a deeper look.
How Does Payment For Order Flow Work?
Here’s a step-by-step guide to how payment for order flow works:
1. A retail investor puts in a buy or sell order on their brokerage account platform.
2. The brokerage firm routes the order to a market maker.
3. The broker collects a small fee or rebate–the “payment” for sending the “order flow.”
4. The market maker is required to find the “best execution,” which could mean the best price, swiftest trade or the trade most likely to get the order done.
The rebates allow brokerages to subsidize rock-bottom or zero-commission trading for customers. It also frees them to outsource the task of executing millions of customer orders.
Business publications have reported that the amount in rebates a brokerage receives is tied to the size of the trades. Smaller orders are less likely to have an impact on market prices, motivating market makers to pay more for them. The type of stocks traded can also affect how much they get paid for in rebates, since volatile stocks have wider spreads and market makers profit more from them.
What Are Market Makers?
Market makers–also known as electronic trading firms–are regulated firms that buy and sell shares all day, collecting profits from bid-ask spreads. The market maker profits can execute trades from their own inventory or in the market. Offering quotes and bidding on both sides of the market helps keep it liquid.
Market makers that execute retail orders are also called wholesalers. The money that market makers collect from PFOF is usually fractions of a cent on each share, but these are reliable profits that can turn into hundreds of millions in revenue a year. In recent years, a number of firms have exited or sold their wholesaling businesses, leaving just a handful of electronic trading firms that handle PFOF.
In addition to profits from stock spreads, the orders from brokerage firms give market makers valuable market data on retail trading flows. When it comes to using institutional or retail investors, market makers also prefer trading with the latter because larger market players like hedge funds can trade many shares at once. This can cause big shifts in prices, hitting market makers with losses.
PFOF in the Options Market
Payment for order flow is more prevalent in options trading because of the many different types of contracts. Options give purchasers the right, but not the obligation, to buy or sell an underlying asset. Every stock option has a strike price, the price at which the investor can exercise the contract, and an expiration date–the day by which the contract expires.
Market makers play a key role in providing liquidity for the thousands of contracts with varying strike prices and expiration dates.
The options market also tends to be more lucrative for the brokerage firm and market maker. That’s because options contracts trading is more illiquid, resulting in chunkier spreads for the market maker.
Criticism of Payment For Order Flow
Payment for order flow was pioneered in the 1980s by Bernie Madoff, who later pleaded guilty to running the largest Ponzi scheme in U.S. history.
Critics argue retail investors get a poor deal from PFOF. Since market makers and brokerages are only required to provide “best execution” and not necessarily the “best possible price,” firms can make trades that are profitable for themselves but not necessarily in the best interest of individual investors. Former U.S. Senator Carl Levin has been one of the most vocal critics of the practice, calling for it to be abolished as recently as January 2021.
In 2016, the U.S. Justice Department subpoenaed market making firms for information related to the execution of retail stock trades. The DOJ was looking into whether the varying speeds at which different data feeds deliver market prices made it look like retail clients were getting favorable prices, while market makers knew they actually weren’t from faster data feeds. A trading firm settled with regulators in 2017.
Defenders of Payment For Order Flow
Proponents of payment for order flow argue that both sides–the retail investors and the market makers–win from the arrangement. Here are the ways retail customers can benefit from PFOF, according to its defenders:
1. No Commissions: In recent years, the price of trading has collapsed and is now zero at the biggest online brokerage firms. While competition has been a big part of that shift, PFOF has helped bring about low trading transactions for mom-and-pop investors. For context, online commissions were $40 or so a trade in the 1990s.
2. Liquidity: Particularly in the options market, where there can be thousands of contracts with different strike prices and expiration dates, market makers help provide liquidity, ensuring that retail customer orders get executed in a timely manner.
3. Price Improvement: Brokerages can provide “price improvement,” when customers get a better price than they would on a public stock exchange. A Bloomberg Intelligence report estimated that the benefit from price improvement for retail clients in 2020 may have totaled $3.7 billion. In addition, a 2020 SEC algo trading report found that PFOF does often offer slightly better prices for individual investors, although the regulator also found that market makers benefit from trading with less informed traders.
4. Transparency: SEC Rules 605 and 606 require brokers to disclose statistics on execution quality for customer orders and general overview of routing practices. Customers are also allowed to request information on which venues their orders were sent to. Starting in 2020, brokers also had to give figures on net payments received each month from market makers.
What Should Investors Know About PFOF?
Payment for order flow is controversial, but it’s undeniably become a key part of financial markets when it comes to stock and options trading today. In 2017, research found that about one in five trades in the U.S. equity market was done through PFOF.
Some brokerage firms rely more on PFOF revenue than others. Retail customers can benefit from looking up their broker’s 605 and 606 disclosures, which show execution quality statistics as well as information on routing practices.
Industry observers have said that for retail investors weighing the trade-off between low trading costs versus good prices, it may come down to the size of their trades. For smaller trades, the benefits of saving money on commissions may surpass any gains from price improvement. For investors trading hundreds or thousands of shares at a time, getting better prices may be a bigger priority.
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