Payment for order flow (PFOF) are fees that broker-dealers receive for placing trades with market makers and electronic communication networks, who then execute the trades.
While supporters of payment for order flow, including brokerage firms, believe that it helps lower trading costs for retail investors, its critics argue that such payments cause a conflict of interest. An increase in retail trading activity and Robinhood brought PFOF into the limelight. Learn how it works and how it impacts your investments.
Definition and Examples of Payment for Order Flow
Payment for order flow is received by broker-dealers who place their clients’ trade orders with certain market makers or communication networks for execution. Broker-dealers also receive payments directly from providers, like mutual fund companies, insurance companies, and others, including market makers.
- Alternative term: PFOF
When you buy or sell stocks, options, and other securities, the broker-dealer who has your account is responsible for executing the trade and getting you the best price available, known as "the best execution."
Broker-dealers can choose from different providers, including themselves, depending on who has the best deal. The Securities and Exchange Commission (SEC), also requires broker-dealers to disclose how much they receive in PFOF and the source of the payments. The payment per share may be a fraction of a penny but can add up due to substantial order volume. In 2020, Robinhood, Charles Schwab, E*Trade, and TD Ameritrade received $2.5 billion in payments for order flow.
Not meeting those two criteria is how Robinhood wound up squarely in the sights of the SEC. In December 2020, the agency charged Robinhood for failing to disclose the payments it received for routing its clients’ orders to market makers between 2015 and 2018. The SEC also said Robinhood misled its customers by not ensuring that they got the best execution on those trades.
“As the SEC’s order finds, one of Robinhood’s selling points to customers was that trading was ‘commission free,’ but due in large part to its unusually high payment for order flow rates, Robinhood customers’ orders were executed at prices that were inferior to other brokers’ prices,” the SEC said in a press release.
Robinhood settled those charges by paying $65 million without admitting or denying SEC’s findings.
How Payment for Order Flow Works
Broker-dealers like Robinhood, Charles Schwab, and TD Ameritrade traditionally had several sources of revenue. They received fees from their customers in the form of trading commissions, sales commissions on mutual funds and other products, margin account fees, and investment advisory fees. However, that has changed with the advent of commission-free trading.
Payment for order flow is how broker-dealers like Robinhood and Charles Schwab can offer their customers low commissions or commission-free trading.
Market makers, who act as buyers and sellers of securities on behalf of an exchange, compete for business from broker-dealers in two ways. First, they compete using the price they can buy or sell for; and, second, they consider how much they are willing to pay to get the order.
Market makers make money by selling a stock for a slightly higher price than they bought it for. The difference is known as the bid/ask spread. Market makers compete for orders from broker-dealers and institutional traders like mutual fund companies. Retail trades from individual investors are especially attractive to market makers because they are generally small and can be turned around quickly for a profit.
When you enter a trade with your broker-dealer to buy or sell a stock, there are four ways to fill the order:
- Internalization: The broker-dealer may send the trade to its own trading arm to execute.
- Direct To Exchange: The order is sent to, and filled directly on, the exchange that the stock is listed on or another exchange.
- Market Maker: The market maker will buy or sell the stock from their inventory at their bid/ask 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 is obliged to get the best execution of their customer's order that is reasonably available. Price, speed of execution, and ability to meet the order are all criteria for where the order will be routed. Broker-dealers are required to regularly review their client orders and where they are getting the most favorable execution.
But there are both supporters and critics of PFOF.
Lower commissions or commission-free trading
Conflict of interest
Costs of inferior execution deals
Lower commissions or commission-free trading: Broker-dealers such as Robinhood make the argument that accepting PFOF has helped them reduce investment costs for their clients.
Conflict of interest: Critics, including some members of Congress, claim that PFOF is a conflict of interest. SEC’s charges against Robinhood outlined that the brokerage had high payment for order flow rates while its clients’ orders were executed at prices that were inferior to other brokers’ prices.
Costs of inferior execution deals: In its allegations against Robinhood, the SEC said that inferior trade execution prices cost Robinhood clients $34.1 million over and above any benefit they received from commission-free trading.
What Payment for Order Flow Means for Individual Investors
For investors who trade stocks regularly, the conflict among zero commissions, PFOF, and best order execution can be hard to quantify. There is conflicting research as to whether PFOF actually improves order execution quality or not.
While generating revenues through payment for order flows has helped broker-dealers compress trading commissions for retail investors, increased retail investing activity and Robinhood have brought PFOF under regulatory scrutiny. Some of these benefits may go away if there is a change in rules.
- Payment for order flow is received by brokers in exchange for routing their clients’ trade orders to market makers for execution.
- Broker-dealers are obliged to ensure that their clients’ trade gets the best execution ahead of any payment the broker receives.
- Brokerages believe PFOF has helped them lower trading commissions for clients.
- Critics of PFOF believe it causes a conflict of interest, as it offers an economic incentive to the broker to route orders to a particular market maker.