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Payment for Order Flow (PFOF)

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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

Best For
Trading Ideas
Overall Rating
Get started securely through public.com’s website
Commissions
$0
Account Min
1 Minute Review

Public is a new social brokerage with a motto of “Everyone’s an investor.” Instead of appealing to sophisticated traders or high net worth clients, Public wants everyone to get a piece of the pie. With no minimums, no commissions and fractional shares for purchase, Public allows anyone to invest in the companies they believe in, regardless of how much capital they have.

Public doesn’t have superior charting tools or complex derivatives, just stocks and ETFs on a basic mobile platform. Clients can follow other investors and copy their trades or develop their own strategy by choosing from preloaded themes or picking individual stocks. Advanced traders need not apply — Public is a brokerage for the class of investor that most major brokerages have decided to leave behind.

Best For
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Global and Active Traders
Overall Rating
Get started securely through Interactive Brokers’s website
Commissions
Account Min
1 Minute Review

Interactive Brokers is a comprehensive trading platform that gives you access to a massive range of securities at affordable prices. You can buy assets from all around the world from the comfort of your home or office with access to over 135 global markets. Options, futures, forex and fund trading are also available, and most traders won’t pay a commission on any purchase or sale.  

IBKR is geared primarily toward experienced traders and investors but now with the availability of free trades with IBKR Lite, casual traders can also acclimate to IBKR’s offerings.

Best For
  • Access to foreign markets
  • Detailed mobile app that makes trading simple
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Best For
Stock Research
Overall Rating
Get started securely through Fidelity Investments’s website
Commissions
$4.95
Account Min
$0 for IRAs. Some accounts may require a minimum opening balance of $2,500
1 Minute Review

Fidelity is a comprehensive and responsive brokerage suitable for both new and experienced traders alike. With complete access to the full U.S. stock and options markets, a set of state-of-the-art education and research tools, as well as a wide fee-free fund selection, Fidelity is equally useful for the veteran swing traders to novices opening their first accounts. Mobile traders will be especially happy with Fidelity’s app, which mirrors full capabilities of the platform. Though there isn’t much to criticize about Fidelity, the broker does have a few areas where it can afford to improve. Margin rates are significantly higher than most other brokers, especially for traders borrowing less than $25,000. It also doesn’t offer any access to the futures markets. Despite these minor flaws, Fidelity remains a strong choice for most investors.

Best For
  • Easy-to-navigate yet functional platform strikes the perfect balance between expert tools and comfort for beginners
  • Mobile trading app is fully-optimized and mirrors full functionality of the desktop platform
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Cons
  • Margin rates higher than many other competing brokerages
  • No access to futures trading
  • High fees for buying a non-Fidelity mutual fund (with over 3,300 fee-free funds available)

Understand PFOF

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?

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Q: What does PFOF stand for?
asked
1

A: Payment For Order Flow: the payment that a brokerage receives from a market maker in exchange for routing their orders through them.

answered

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