Now that almost every brokerage has followed in the footsteps of Robinhood and adopted commission-free trading, how do these companies make money? One main source of revenue is from a small sum of money from market makers in exchange for routing client orders through them.
This practice is known to the investing world as payment for order flow (PFOF). Learn more now.
What is Payment for Order Flow?
Payment for order flow (PFOF) is the payment that a brokerage receives from a market maker in exchange for routing their orders through them. A market maker is an entity that provides liquidity on both the bid and the ask for a security, seeking to profit from the spread between the 2 quotes.
For the past 20 or so years, the spreads for most securities have continued to narrow. In order to combat this, market makers such as Citadel Securities have paid a small sum to brokerages in order for them to route their clients’ orders through them.
The New York Stock Exchange has actual human “specialists” on the floor that serve this function. In contrast, the fully-electronic Nasdaq exchange has around 14 market makers for each security, all competing with each other to provide liquidity.
How Payment for Order Flow Works
PFOF is a fairly simple, yet often hidden, business relationship between brokerages and market makers. Surprisingly, or perhaps not, notorious crook Bernie Madoff pioneered this practice back in the 1990s.
As of 2005, PFOF became more regulated by the SEC when it started requiring disclosures from brokerage firms. Today, when you open an account, your broker must tell you if it engages in this practice. It also has to provide updates on an annual basis concerning any changes to its PFOF practices.
Promotions on Price Improvement
Although there are a handful of arguments in favor of PFOF, a primary claim is that it results in orders being filled at better prices. While this technically may be true, another reason is because market makers consider retail investors to be “dumb money.”
As a result, market makers may feel they incur less risk in filing these orders. This can result in a better price than is offered on the public exchange.,
But just because the average investor’s order is filled at a slightly better price does not mean they reap the rewards from PFOF.
Another common argument in favor of PFOF is that it promotes price improvement. In other words, the theory is that the average trade is filled at a better price than the National Best Bid and Offer (NBBO).
Profits from Order Flow
Brokers receive payments for order flow from third parties on either a per-share or per-dollar basis. PFOF transfers some of the market makers’ profits to the brokerage, but market makers realize profits from the arrangement as well.
For instance, market makers can package orders together and front run them, use the added liquidity to increase spread arbitrage, and even take the other side of the retail order. While these may all sound dangerous to the retail investor, the fact of the matter is that PFOF is largely what has allowed commission-free trading to be offered by brokerages.
Payment for Order Flow Risks
There are multiple risks that stem from PFOF in addition to these market makers taking the other side of your trade. For one, the prevalence of PFOF arrangements has moved a lot of the trading volume off of the public exchanges.
Most of the volume that is left on these public exchanges is from more informed traders that don’t want their orders routed through these PFOF schemes. The presence of more experienced traders means it is more risky for market makers to take the other side of these trades.
This can result in increased spreads, punishing these traders. And since the retail investor has far more access to relevant information today, these PFOF schemes can also expose these market makers to increased risk (i.e r/wallstreetbets GME pump).
Incentives Surrounding PFOF
Some of the incentives resulting from PFOF have changed the dynamics of the market. One such change is increased spreads on public exchanges, as market makers are more hesitant to take the other side of these more experienced traders’ orders. This punishes more informed traders and could force more and more trading volume into PFOF channels.
Another potential incentive is for market makers to maintain their informational advantage over retail traders. Much of the benefits that market makers receive from PFOF stems from taking the other side in trades by “dumb money.” Accordingly, there seems to be an incentive to try and keep these retail traders from becoming seasoned investors.
Can I Avoid a Payment for Order Flow?
While PFOF has become widespread, it is still simple to avoid it. All you need to do is open up a brokerage account with a broker that does not accept PFOF. These brokerages will either route your orders through market makers that don’t pay for order flow or give you direct market access.
Brokers that Don’t Sell Your Order Flow
Some retail brokerages that target more informed investors do not engage in PFOF. An example is Interactive Brokers.
Other brokerages target more experienced active traders and give users direct access to the market through whichever route they choose. Some brokerages that do this include Lightspeed and TradeStation.
Another option is the recent development of a tip-based model by some commision-free brokerages such as Public.
PFOF is an integral part of stock market function. However, there has been much criticism surrounding the practice, especially since the congressional hearings on GME.
While there certainly are drawbacks to PFOF, an undeniable benefit is the adoption of commission free trading by most brokerages. While PFOF may not be serving these new market participants perfectly, without it, many would not be market participants at all.
Frequently Asked Questions
Q: What does PFOF stand for?
A: Payment For Order Flow: the payment that a brokerage receives from a market maker in exchange for routing their orders through them.
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