As an investor, you may have come across the term “payment for order flow” and wondered what it meant. In this blog post, we’ll explain what payment for order flow is and how it works. We’ll also discuss who benefits from it and whether or not you should be concerned about it as an investor. By the end of this post, you should have a good understanding of payment for order flow and how it impacts the investing landscape.
Table of Contents
Introduction to Payment for Order Flow (PFOF)
Payment for order flow is a system where brokerages are paid to route their orders through certain market makers or trading firms. This practice is controversial because it can conflict with the best interests of the investor, who may not be getting the best possible price for their trade.
Some brokerages, like Robinhood, have been criticized for allegedly profiting from order flow at the expense of their customers. In fact, Robinhood was fined $65 million in December 2020 by the SEC on account of “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders.” This was for their practices occurring between 2015 – 2018.
The SEC has in place rules that would increase transparency around payment for order flow and other trading practices. These rules are intended to help protect both investors and brokerages alike. The rules would require brokerages to disclose their payments to market makers and trading firms. This information would be posted on the SEC’s website, so investors could easily see who was benefiting from their orders.
Some argue that these rules are too lenient, given the history of payment for order flow abuses by some brokerages. Others say that the benefits of increased transparency outweigh the drawbacks. Whichever side you take, it’s clear that payment for order flow is an important issue that needs to be monitored closely by regulators.
Payment for order flow is a practice that is currently banned in several countries, namely Britain, Australia and Canada. As such, there has been discussion and various parties pushing for a ban on this practice in the United States as well. Despite this, the SEC issued a statement on September 2022 confirming that there will not be a ban on it.
How Does Payment For Order Flow Work?
Stock Market Basics Simplified
In the stock market, there are buyers and sellers of stock and other derivatives (i.e. options). They are constantly putting out prices at which they are willing to purchase or sell their stock or other derivatives. These are called trades. In the stock market, all these trades happen on an exchange whose role is there to match the trades between buyers and sellers so that transactions can go through. Some example of exchanges are the New York Stock Exchange (NYSE), the Chicago Board Options Exchange (CBOE) and the National Association of Securities Dealers Automated Quotations (NASDAQ).
Another Player: The Market Makers
Besides the investors, there is another player in the stock market known as the market makers. They could be individuals or a firm who will continuously quote on both the buy and sell side of the market. Their role is to ensure that buyers or sellers will always be able to fill their trades quickly, keeping the market liquidity good. They earn by the spread between the buy/sell quotes that they make.
How Does Payment For Order Flow Happen?
Payment for order flow comes into play when brokers, like Robinhood, direct their users’ trades to either an exchange or a market maker. In return, Robinhood gets paid a small fee on each trade for doing so. With the sheer volume of trades coming in on Robinhood, the fee quickly adds up and can be a very significant contributor to the revenue stream of brokers.
Benefits Of Using Payment For Order Flow
1) 0% Commissions On Stock and Options Trading
The payment for order flow trend has been growing in popularity because it allows retail investors to trade without having to pay commissions. This can be beneficial for them, especially if they do high frequency trading. This allows them to enter and exit their stock or option positions frequently avoiding any commission fees which would usually add up to quite a fair bit in trading.
2) Better Market Efficiency and Liquidity?
Some who favour the use of payment for order flow claim that it helps to improve market efficiency and liquidity. Smaller brokers may not have the capacity to handle large volume of trades and by routing the trades to exchanges and market makers, the efficiency is improved.
So, Why Then The Controversy Of Using Payment For Order Flow?
As part of the responsibility of brokers, they have a fiduciary duty to ensure their clients are getting the best price for the trades that they place. However, that may not always be the case in real practice. This is even more so, if the order flow is channelled through a market maker who earns on a spread between the buy/sell trades. Since the 1990s, there have been many cases of brokers profiting from their clients trades, while not upholding their very duty towards their clients itself. As such, there has been always been a controversy surrounding this practice.
One of the most recent high profile case relating to payment for order flow is the one involving Robinhood.
Robinhood And Payment For Order Flow
Robinhood is a popular stock trading platform that offers investors the opportunity to trade stocks without paying commissions. In order to make money by selling order flow, Robinhood takes a commission from the trades that are executed through its platform. This means that it makes money by routing customer orders to market makers or exchanges for execution.
In total, Robinhood was fined three times:
- Financial Industry Regulatory Authority (FINRA) fine of $1.25 mil in December 2019
- Securities and Exchange Commission (SEC) fine of $65 mil in Dec 2020
- Financial Industry Regulatory Authority (FINRA) fine of $57 mil in June 2021 with added $12.6 million of restitutions to their investors.
Other Brokers And Order Flow Providers
The practice of accepting payment for order flow is not unique to only Robinhood. Many other brokers to make use of this practice, namely:
- TD Ameritrade
- Charles Schwab
- Ally Invest
- Bank of America
- Wells Fargo
In fact, for the second quarter of 2022, these top 10 firms received a total of approximately $709 million, as reported on Daytradingz.
Should You Care About Payment For Order Flow As An Investor?
As an investor, it is important to understand about payment for order flow, as it could potentially impact you as you participate in the stock market. Selling order flow affects investors in two ways: first, it can drive up prices (by increasing demand). Second, it can reduce liquidity (which could lead to higher prices and more volatility). While these effects are often short-term, they should still be taken into account when analyzing a stock.
Ultimately, whether or not you should care about payment for order flow depends on your investment strategy and goals. If you are primarily concerned with long-term performance, then you may not need to pay attention to this information. However, if you are looking to make short-term investments, then paying attention to payment for order flow could be beneficial.
To Sum Things Up
Payment for order flow is a system where brokerages are paid to route their orders through certain market makers or trading firms. This practice is controversial because it can conflict with the best interests of the investor, who may not be getting the best possible price for their trade. Some brokerages, like Robinhood, have been criticized and fined for allegedly profiting from order flow at the expense of their customers.
However, there are also some benefits to allowing payment for order flow, which is probably the reason why the Securities and Exchange Commission (SEC) has made a decision not to ban it as per their announcement on September 2022.
As an investor, it is important for you to understand what this practice entails as it could potentially not be in your best interests while you’re investing in the stock market. However, it is ultimately up to each individual to assess the risk of using a broker who accepts payment for order flow and decide whether you can accept it or prefer to select other brokers.