Payment for order flow is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. The brokerage firm receives a small payment, usually a penny per share, as compensation for directing the order to different third parties.
Breaking Down Payment For Order Flow
The nature of compensation for order flow is what is essential. In payment for order flow scenario, a broker is receiving fees from a third party, at times without a client's knowledge. This naturally invites conflicts of interest and subsequent criticism of this practice. Today, most brokers offer clear policies surrounding this practice.
This is a major benefit for smaller brokerage firms, which can't handle thousands of orders. In effect, this allows them to send off their orders to another firm to be bundled with other orders to be executed. This helps brokerage firms keep their costs low. The market maker or exchange benefits from the additional share volume it handles, so it compensates brokerage firms for directing traffic.
Your brokerage firm is required by the SEC to inform you if it receives payment for sending your orders to specific parties. It must do this when you first open your account as well as on an annual basis. The firm must also disclose every order in which it receives payment.
Payment for Order Flow Cost Savings
The cost savings from payment for order flow arrangements shouldn't be overlooked. Investors, particularly retail investors, who often lack bargaining power can greatly benefit from the competition to fill their order requests. However, as with any gray area, arrangements to steer the business in one direction invite improprieties, which can chip away at investor confidence in financial markets and their players.
Ironically, payment for order flow is a practice pioneered by Bernard Madoff — the same Madoff of Ponzi scheme notoriety. During its existence, the practice has mostly been shrouded in controversy. But its allure is too strong, with even the New York Stock Exchange adopting it in 2009.