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What Is Payment for Order Flow?

Sebencapital

Published
08/01/24

DEFINITION:

Payment for order flow (PFOF) refers to fees that broker-dealers get for sending trades to market makers and electronic communication networks, which then carry out those trades.

Definition and Examples of Payment for Order Flow

Broker-dealers get payment for order flow when they send their clients' trade orders to specific market makers or communication networks to be carried out. They also receive payments from various providers like mutual fund companies, insurance companies, and others, including market makers.

  • Alternative term: PFOF

Note

When you purchase or sell stocks, options, or other securities, the broker-dealer handling your account is in charge of making the trade happen and getting you the best possible price, which is called "the best execution."

Broker-dealers have options for providers, including themselves, based on who offers the best deal. The Securities and Exchange Commission (SEC) requires broker-dealers to reveal the amount received from PFOF and its source. Although the payment for each share may be small, it can accumulate due to high order volumes. In 2020, companies like Robinhood, Charles Schwab, E*Trade, and TD Ameritrade collectively received $2.5 billion from payments for order flow.

Robinhood faced SEC scrutiny for not meeting these criteria. In December 2020, the SEC charged Robinhood for not disclosing payments received for directing clients' orders to market makers between 2015 and 2018. Additionally, the SEC accused Robinhood of not ensuring customers received the best trade execution.

The SEC stated, "Robinhood attracted customers by offering 'commission-free' trading, but due to its notably high payment for order flow rates, Robinhood customers' trades were executed at lower prices than other brokers'."

Robinhood settled the charges by paying $65 million, without admitting or denying the SEC's findings.

How Payment for Order Flow Works

Companies such as Robinhood, Charles Schwab, and TD Ameritrade used to earn money from various sources. They got fees from customers like trading commissions, sales commissions on mutual funds, margin account fees, and investment advisory fees. But things changed when commission-free trading became more common.

Note

Payment for order flow enables broker-dealers like Robinhood and Charles Schwab to provide their customers with low commissions or commission-free trading.

When market makers operate on behalf of an exchange, they compete in two ways for business from broker-dealers. First, they compete based on the price at which they can buy or sell securities. Second, they consider how much they're willing to pay to receive the order.

Market makers earn profits by selling a stock at a slightly higher price than the one they bought it for. This difference is called the bid/ask spread. They vie for orders from broker-dealers and big traders like mutual fund companies. Market makers find trades from individual investors appealing because they are usually small and can be quickly turned around for profit.

When you make a trade with your broker-dealer to buy or sell a stock, there are four methods to complete the order:

  • Internalization: The broker-dealer might send the trade to its trading division to carry out the transaction.
  • Direct To Exchange: The order is sent to and filled directly on the exchange on which the stock is listed or another exchange.
  • Market Maker: The market maker will purchase or sell the stock from their stockpile at their offered price.
  • Electronic Network: Electronic networks match buyers and sellers based on specified prices. Broker-dealers often route limit orders to ECNs.

Pros and Cons of Payment for Order Flow

A broker-dealer must aim to fulfill their customer's order in the best possible way that's reasonably accessible. They consider factors like price, how quickly the order is processed, and if it can be fulfilled when deciding where to send the order. Broker-dealers must consistently assess their client orders to ensure they get the most beneficial execution.

However, opinions on payment for order flow (PFOF) vary among both advocates and critics.

Pros

  • Reduced fees or trading without commission

Cons

  • Clash of interests
  • Expenses from less favorable trade executions

Pros Explained

Reduced fees or free trading: Brokerage firms like Robinhood claim that accepting PFOF has allowed them to cut down expenses for their customers' investments.

Cons Explained

Expenses due to poor trade execution: The SEC claimed that Robinhood's clients lost $34.1 million because of lower trade prices, surpassing any gains they received from commission-free trading.

What Payment for Order Flow Means for Individual Investors

For active stock traders, the clash between zero commissions, payment for order flow (PFOF), and getting the best trade execution is challenging to measure. There's mixed research on whether PFOF genuinely enhances the quality of trade execution or not.

Broker-dealers have used payment for order flows to reduce trading fees for everyday investors, but with the rise in retail investing, especially with platforms like Robinhood, regulators are scrutinizing PFOF practices. If rules change, some of these advantages might diminish.

Key Takeaways

  • Brokers receive payment for order flow when they send their customers' trade requests to market makers for execution in return.
  • Broker-dealers must make sure that their clients' trades get the best possible execution, prioritizing this before any payment the broker might receive.
  • Brokerages think that Payment for Order Flow (PFOF) has assisted them in reducing trading fees for their customers.
  • Opponents of Payment for Order Flow (PFOF) argue that it creates a conflict of interest because it provides a financial incentive for the broker to direct orders to specific market makers.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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