Payment for order flow PFOF: what it is and why it’s controversial

The broker receives the order and routes it to a market maker, who offers to sell it at $99.00 but first buys it for $98.90 and keeps the $0.10 difference. It might not seem like a lot, https://www.xcritical.com/ but market makers execute many trades a day, so those cents add up. Online brokers with zero-commission trading tend to attract a wide array of investors. It takes a level of responsibility off of the retail customer, allowing them to learn as they go and make decisions based on the stock markets performance, not broker fees. Grasping how PFOF works enables investors to appreciate how no trade is really free because if they aren’t paying for the services involved in trading, then someone else is.

Which brokers earn revenue through payment for order flow?

In addition to regulatory and enforcement updates, please contact us if you have any questions about your current risk exposures, controls, and compliance improvement opportunities. More broadly, we are seeing talk in regulatory and policy circles about banning PFOF entirely. The issue proved costly to Robinhood, resulting in an agreed settlement of $65 million. It was only one of many issues the company faced from both federal and pfof meaning state regulators.

Research Spotlight: Payment for Order Flow and Price Improvement

This is such a common occurrence that traders are often convinced stocks will drop as soon as they make their entry and thus hesitate until FOMO (fear of missing out) prompts them to chase an entry at the top. One vendor (market maker) says they’ll personally pay you a penny if you send him the order. The S&P SmallCap 600 is a stock market index introduced by Standard & Poor’s.

• 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.
• They are firms that stand ready to buy and sell securities at all times, providing liquidity to the market.
• Investors could be paying fees unwittingly for their “no-commission” trades.
• Traders should monitor their trade execution quality and ask their broker about their order routing practices.
• However, PFOF is part of the business model of most commission-free brokers although Public has chosen not to accept PFOF.
• Payment for order flow is a controversial topic since it’s not always clear whether it benefits or hurts consumers.
• If consumers could readily discern the differences in execution quality across brokers, then this alone would not be a problem.

What Is Payment for Order Flow (PFOF)?

It allows them to trade profitably against client orders, while their retail clients theoretically benefit from lower or no commissions. Another criticism of PFOF is that it creates a conflict of interest for brokers, who are supposed to act in the best interest of their clients. Critics argue that brokers may be tempted to sell their clients’ orders to market makers that offer the highest rebates, rather than to venues that offer the best execution quality.

Criticisms of payment for order flow

To put this in context, prior literature has estimated PI at 5 to 9 basis points. This suggests that using the NBBO as a benchmark overstates PI by as much as 400%, i.e., removing the 4 basis point bias leads to actual PI of 1 to 5 basis points. With order flow arrangements, traders have no control over how their orders are routed and can expect to run into issues trying to execute larger sized trades. Often times, larger sized limit orders won’t get filled quickly or completely unless the market maker knows there are large seller orders in his book. At that point, you can expect to get filled as the bids drop afterwards. Exchanges will pay for order flow to promote itself and galvanize its reputations as a source of liquidity for institutional clients, listed companies and companies seeking to IPO.

Until then, member states can allow PFOF but only for clients in that member state. So Trade Republic can earn money through PFOF for its German clients until 2026, but not for its Belgian clients for instance. The practice is perfectly legal if both parties to a PFOF transaction execute the best possible trade for the client. Legally, this means providing a price no worse than the National Best Bid and Offer (NBBO). Brokers are also required to document their due diligence, ensuring the price in a PFOF transaction is the best available. PFOF dates back to at least 1984, and one of its original most vocal proponents was Bernie Madoff, who described it as a way for market makers to outsource the task of finding orders to fulfill.

Figure 1 presents the proportion of orders which execute at a given EFQ or better. Using direct orders as the benchmark, roughly 20% execute at the mid-price or better (with an EFQ of 0% or better). Consistent with the notion that PFOF can benefit retail investors, more than 75% of orders routed to TD Ameritrade execute at the mid-price or better.

In December 2019, FINRA fined Robinhood $1.25 million for earlier best execution violations. Most people have heard of the New York Stock Exchange and Nasdaq, but there are dozens of other venues in total that can “trade” stocks. All we do know is that a PFOF ban will most likely hurt the retail investor. You are now leaving the SoFi website and entering a third-party website. SoFi has no control over the content, products or services offered nor the security or privacy of information transmitted to others via their website. We recommend that you review the privacy policy of the site you are entering.

The market makers execute the trade, and gives the brokerage a tiny portion of the trade value as a way to thank the brokerage for sending business their way. A market maker is an individual or financial firm committed to making sure there are securities to trade in the market. Market makers are essential to maintaining an efficient market in which investors’ orders can be filled (otherwise known as liquidity).

Because some market makers will offer a higher monetary incentive to brokerages than others, there are times when a company may prioritize profit over the best possible price for the client. While brokerage firms are not legally upheld by the fiduciary standard, they are bound by the best interest standard, which states that transactions must be in the best interest of client. This criticism of PFOF is one reason why Public decided not to use the practice in its own business model. One of the stock market myths is that commission free trades are actually free.

This is a bracket, which represents the highest prices buyers are willing to pay, the bid, and the lowest prices sellers are willing to sell, known as the ask price. However, PFOF is part of the business model of most commission-free brokers although Public has chosen not to accept PFOF. Get the best possible price execution for your trades with Public—a PFOF-free investing platform. Because of the controversy, the European Union has decided to ban payment for order flow from 2026 onwards.

Still, any moves by the SEC to curtail PFOF would affect millions of investors. Market makers are licensed and regulated and play an essential role in the stock market by providing liquidity, setting bid-ask spreads, facilitating the exchange of securities, and managing order flow. 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. 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. It’s important to understand what happens when an investor chooses to trade a security.

Brokers’ commissions have changed with the rise of low-cost alternatives and online platforms. To compete, many offer no-commission equity (stock and exchange-traded fund) orders. The SEC proposed Rule 615, the “Order Competition Rule,” which would require broker-dealers to auction customer orders briefly in the open market before executing them internally or sending them to another trading center. This is intended to allow others to act on these orders, providing greater competition and potentially better results for investors.

Investors could be paying fees unwittingly for their “no-commission” trades. In 2021, the SEC expressed concern about orders flowing to the dark market, where the lack of competition among market makers executing trades could mean that brokerages and their customers are being overcharged. The lowering of fees has been a boon to the industry, vastly expanding access to retail traders who now pay less than they would have previously. However, these benefits would disappear any time the PFOF costs customers more through inferior execution than they saved in commissions. There are major differences in how market makers and other “wholesalers” compensate brokers for executed trades.

Retail brokers typically route orders to a handful of market makers, allocating more to the market makers that provide the highest amount of price improvement to the retail investors. Payment for Order Flow (PFOF) is a controversial topic in the world of trading as it has been a major source of revenue for market makers. Market makers make money from PFOF by executing trades on behalf of their clients and selling the order flow data to third-party firms. In essence, they act as intermediaries between buyers and sellers, and this allows them to generate profits in different ways. On one hand, they can earn a spread, which is the difference between the bid and ask prices of a security. On the other hand, they can earn a rebate from the exchanges for adding liquidity to the market.