How payment for order flow works
Payment for order flow is an oft-ignored activity during securities transaction processing that clings to the underbelly of the modern discount brokerage revenue model. The exercise entails routing customer orders (i.e., flow) to a preferred exchange or market maker in return for payment.
Exchanges are a location where an operating company facilitates securities trading. Market makers are vendors who buy and sell specific securities to provide the market with liquidity. Market makers act as middle persons between buyers and sellers since they are generally always willing to buy or sell a particular holding, hence the name.
When directing orders to a preferred processor or exchange for compensation, brokerage firms generally receive fractions of a penny, which adds up. In fact, during the height of the US Covid lockdowns, Robinhood made more than $720,000,000 from transaction-based revenue in 2020 alone, which they define as payment for order flow (PFOF) and rebates.
But why would exchanges or vendors pay to direct order flow? Because exchanges receive compensation for every trade on their platform through transaction costs end users pay. Maker markers, meanwhile, earn more as transaction processing increases. After all, the processor makes a profit on the spread between the bidding and asking price of securities.
The bidding price is what the vendor is willing to pay you when you sell to them. And asking price is what they are ready to sell a security to you. The names reference the vendor’s position; bidding equals the most they will bid to buy, and asking equals the least they are asking to sell.
In return for the increased order flow, market makers can profit off the difference between the bidding and asking price, known as the spread. The spread can be as small as a penny for highly traded securities or over several dollars for infrequently traded securities. Spreads can vary due to each security’s risk (known as non-systemic risk) since prices can swing instantaneously.
If the maker knows they can buy and resell something fast, they are willing to take a smaller profit spread. However, if the transaction takes longer to close, it will require a more significant profit margin to account for price swings so the maker can remain solvent.
Thus, given increased revenues from transaction processing, an incentive to pay for order flow exists for exchanges and market makers. As an aside, market makers may not always profit and can lose money on transactions when providing liquidity.
Regulation & research
It is important to note that the Securities & Exchange Commission (SEC) requires brokers to fill customer orders for the best possible price and disclose their use of payment for order flow (PFOF).
Many have suggested and argued that PFOF could cost end consumers since they may not receive the best execution price (i.e., purchase or selling price). After all, PFOF acts as a conflict of interest for brokers when certain vendors are willing to pay more for processing than others.
However, recent academic research has shown that these worries are unsupported by facts. Further, when the SEC studied the subject in 2000, they reached a similar conclusion.
Nevertheless, the perception that payment for order flow could harm consumers through suboptimal pricing has lingered since the early 1990s.
Commentary on the benefits & drawbacks
So, is payment for order flow foul? Is it unethical?
Partially yes, but also no.
PFOF presents multiple conflicts of interest for brokerage firms since they must put the customer’s transaction before profits when routing orders while concurrently not encouraging excess trading to generate revenue.
While the first has been adhered to by the brokerage industry, the second potentially has not. In 2021, the SEC speculated that brokerage firms might be engaging in gamification of trading to increase customer order volumes and PFOF revenue.
At this point, the verdict is inconclusive on whether or not brokerages have encouraged excessive customer trading to increase profits. It will take time to prove or refute these claims, and as of now, PFOF remains legal and unchanged.
Meanwhile, a benefit PFOF provides is increased liquidity since more vendors are vying for transaction revenue. However, vendors may compete for brokerage customer trades because they can segment the market to compete against retail investors instead of others.
Such market segmentation can put hedge funds and other advanced off-market makers directly against retail investors, which the WSJ notated earlier this year:
“[These sophisticated firms] make more money by trading against small investors than they do on public exchanges, where they might find themselves trading with other sophisticated trading firms or institutional investors.”
WSJ: SEC Closes In on Rules That Could Reshape How Stock Market Operates
In a nod to the conflicts that the current payment for order flow system maintains, the SEC has proposed switching order routing to one where the highest bidder of an auction fills it. Thus, brokerages and middle persons would have to put the end customer first.
In Closing
Payment for order flow is a contentious topic that deserves further debate in the public arena. If you are unsure how your broker routes your transactions, call them and find out. Further, share your thoughts directly with the SEC using this link.
For investors who want to avoid associating with brokers that pay for order flow, I encourage you to research firms that do not partake in the activity. Examples include Fidelity Investments and Vanguard. If you are trying to determine which brokerage firm to use, here is a guide: How You Should Choose A Brokerage Firm.
Thanks for reading, and as always, have a great day!
FAQs
Is Payment for Order Flow Legal?
Yes, PFOF is legal in the United States as of 2022. However, the SEC has proposed making changes to the current model.
What is payment for order flow?
It entails routing customer orders (i.e., flow) to a preferred exchange or market maker in return for payment. I.e., payment for order flow (PFOF).
Which brokers do payment for order flow??
Charles Schwab, Robinhood, TD Ameritrade, and WeBull are a few examples of firms that utilize PFOF.
Mile High Finance Guy
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