Payment for Order Flow (PFOF)

What Is Payment for Order Flow (PFOF)?

Payment for order flow (PFOF) is a form of compensation, usually in terms of fractions of a penny per share, that a brokerage firm receives for directing orders for trade execution to a particular market maker or exchange.

Payment for order flow is common in options markets, and is increasingly found in equity (stock market) transactions.

Key Takeaways

  • Payment for order flow (PFOF) is the compensation a broker receives for routing trades for trade execution to a particular market maker.
  • According to the SEC, payment for order flow is a method of transferring some of the trading profits from market making to the brokers routing the orders.
  • PFOF has been criticized for creating potentially unfair or opportunistic conditions at the expense of retail traders and investors.
  • Brokers are required by the SEC to inform clients of compensation they receive for routing their orders to a particular market maker.
  • Potential advantages of PFOF may include better execution prices and greater market liquidity.

Understanding Payment for Order Flow (PFOF)

Equity and options trading has become increasingly complex with the proliferation of exchanges and electronic communication networks (ECNs). Although the notorious Bernard Madoff was an early practitioner of payments for order flow, the practice is perfectly legal provided both parties to a PFOF transaction fulfill their duty of best execution for the customer initiating the trade.

At a minimum, that means providing a price no worse than the National Best Bid and Offer (NBBO). Brokers are also required to document their due diligence procedures ensuring the price obtained in a PFOF transaction was the best available from a variety of alternative order destinations.

According to the U.S. Securities and Exchange Commission (SEC), “payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.” The legitimate purpose of PFOF transactions is liquidity, not the chance to profit from providing an inferior execution price.  

The complexity of executing orders on thousands of stocks that can be traded on multiple exchanges has increased market participants' reliance on market makers.

These typically large firms may specialize in certain stocks and options, maintaining an inventory of shares or contracts and offering to buy as well as sell them. Market maker compensation is based on the spread between the bid and ask prices.

Spreads have been narrowing, especially since exchanges transitioned from quoting share prices in fractions to decimals in 2001. That's left market makers increasingly dependent on the volume of orders sent their way and has given them incentives to offer PFOF to secure it.  

SEC Requirements and PFOF Regulation

Despite a brokerage firm's obligation to provide a best execution, the SEC has acknowledged that payment for order flow "may raise concerns about whether a firm is meeting its obligation of best execution to its customer." Such concerns can chip away at investor confidence in the financial markets.

The SEC requires brokers to disclose their policies surrounding this practice. They must publish reports that explain their financial relationships with market makers, as mandated since 2005 by Regulation NMS.

Your brokerage firm is required to inform you when you first open your account and annually of payment it receives for sending your orders to specific parties. In addition, brokerage customers can request payment data for specific transactions from their brokers, though it can take weeks to receive a response. Upon request, a firm must disclose every order for which it receives payment.  

Updates: SEC Rules 605 and 606

According to SEC Rule 605 and Rule 606, broker-dealers are required to make two reports available to investors. These reports disclose execution quality and payment for order flow statistics, respectively. The SEC mandated these reports in 2005. The format and reporting requirements have changed over the years, with updates made in 2018 and beyond.

A working group of brokers and market makers created to standardize reporting of order execution quality has dwindled to just a single retail brokerage (Fidelity) and a single market maker (Two Sigma Securities).

The Financial Information Forum (FIF) notes that the Rule 605 and Rule 606 reports “do not provide the level of information that allows a retail investor to gauge how well a broker-dealer typically fills a retail order when compared to the ‘national best bid or offer’ (NBBO) at the time the order was received by the executing broker-dealer.”

Rule 606 specifics were updated in the first quarter of 2020. The changes required brokers to disclose net payments received each month from market makers for trades executed in S&P 500 and non-S&P 500 equity trades, as well as options trades.

Brokers must also disclose their rate of payment for order flow per 100 shares by order type (market orders, marketable limit orders, non-marketable limit orders, and other orders). 

Potential Benefits of PFOF

Smaller brokerage firms that may have trouble handling large numbers of orders can benefit from routing some of those to market makers. Brokers receiving PFOF compensation may be forced by competition to pass on some of the proceeds to customers, in the form of lower costs and fees. However, such benefits could be diminished if PFOF is costing the customers money through inferior execution.

A 2020 SEC report found that PFOF at times did offer better prices for individual investors. Increased liquidity and no-commission trading are other ostensible advantages offered by PFOF.

Hidden Fees

Investors unknowingly may be paying fees for their "no-commission" trading. Recently, the SEC expressed concern about orders flowing to the dark market, where the lack of competition among market makers executing trades may mean that brokerages and their customers are being overcharged. It is studying whether to reform or bar PFOF.

Criticisms of Payment for Order Flow 

The practice of PFOF has always been controversial. Some firms that offered zero-commission trades during the late 1990s routed orders to market makers that did not keep investors’ best interests in mind.

This was during the waning days of fractional pricing, and for most stocks, the smallest spread was ⅛ of a dollar, or $0.125. Spreads for options orders were considerably wider. Traders discovered that some of their free trades were costing them quite a bit because they weren’t getting the best price at the time the order was executed.  

The SEC stepped in and studied the issue in-depth, focusing on options trades. It found, among other things, that the proliferation of options exchanges and the additional competition for order execution narrowed the spreads.

Options market makers argued that their services were necessary to provide liquidity. However, in its conclusion, the SEC wrote:

“While the fierce competition brought on by increased multiple-listing produced immediate economic benefits to investors in the form of narrower quotes and effective spreads, by some measures these improvements have been muted with the spread of payment for order flow and internalization.”

One rationale for allowing PFOF to continue is its role in fostering competition and limiting the market power of exchanges.

PFOF became the subject of renewed controversy in 2021, when the SEC report on the retail investor mania for GameStop Corp. (GME) and other meme stocks suggested that some brokerages may be encouraging their customers to trade to profit from PFOF. In December 2020, the SEC fined Robinhood Markets Inc. (HOOD) $65 million for failing to properly disclose to customers PFOF payments it received for trades that did not result in best execution.

Equity PFOF Trends

Richard Repetto, the Managing Director of Piper Sandler & Co., a New York-based investment bank, published a report that dives into the statistics gleaned from Rule 606 reports filed by brokers. 

For the second quarter of 2020, Repetto focused on four brokers: Charles Schwab, TD Ameritrade, E*TRADE, and Robinhood. Repetto reported that payment for order flow was significantly higher in the second quarter than the first due to increased trading activity. The payment was higher for options than for equities. 

Quarterly Payment for Order Flow Received by Security Type, 2020

What's Payment for Order Flow?

Payment for order flow, or PFOF, is the routing by a brokerage firm of trade orders to specific market makers for execution. The market maker pays the brokerage for forwarding an order. Brokerage firms' PFOF statistics are studied for potential conflicts of interest, where a brokerage puts its clients' order executions at risk for the sake of profit.

Is Payment for Order Flow Good or Bad?

It depends on who you ask. Some fear that investors fail to get the best available execution when their brokers use PFOF. There is concern that profit is a broker's main objective, not a client's best interest. However, others argue that PFOF allows for zero-commission trading, greater market liquidity, and even orders executed at better prices—all of which are advantages for investors.

Is Payment for Order Flow Legal?

Yes, despite being controversial, payment for order flow remains a legal practice, so long as it does not involve illegal activities like frontrunning and does not put the customer at a clear disadvantage. The SEC has signaled that it plans to revisit PFOF as part of its agenda beginning in 2022, but market experts do not anticipate a ban.

When Did Payment for Order Flow Begin?

While it is not known for certain when PFOF arrangements first appeared, the SEC attributes the rise of payment for order flow to the advent of multiple options exchanges, starting in 1999, where the same options series could be listed simultaneously on more than one exchange. This fact led to exchanges competing for where options trades should be routed, including rebates or incentive payments to the broker or customer for directing their order accordingly.

What Is a Market Maker?

A market maker (MM) is an individual or financial firm committed to actively making a market in certain securities. Market makers are essential to maintaining an efficient market in which investors' orders can be filled (otherwise known as liquidity).

The Bottom Line

Industry-wide, brokers’ commission structures have changed. Many offer no-commission equity (stock and exchange-traded fund) orders. As a result, payment for order flow has become a major source of revenue.

For the retail investor, the problem with PFOF is that their brokerage might be routing orders to a particular market maker solely for its own benefit, and not the investor’s. 

Investors who trade infrequently or in very small quantities may not feel the effects of their brokers' PFOF practices. However, frequent traders and those who trade larger quantities should learn more about their brokers' order routing process to make sure that they’re not losing out on price improvement

Article Sources
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  1. FINRA. "FINRA Reminds Member Firms of Requirements Concerning Best Execution and Payment for Order Flow."

  2. U.S. Securities and Exchange Commission. "Special Study: Payment for Order Flow and Internalization in the Options Markets."

  3. U.S. Securities and Exchange Commission. "Final Rule: Regulation NMS."

  4. U.S. Securities and Exchange Commission. "Special Study: Payment for Order Flow and Internalization in the Options Markets," Part B.

  5. U.S. Securities and Exchange Commission. "Division of Trading and Markets Disclosure of Order Execution and Order Routing Information (Rules 605 and 606 of Regulation NMS)."

  6. U.S. Securities and Exchange Commission. "Disclosure of Order Handling Information."

  7. Two Sigma Securities. "Retail Execution Quality Statistics-Wholesale Market Maker Perspective."

  8. Fidelity Brokerage Services LLC. "Retail Execution Quality Statistics Q1 2022."

  9. Financial Information Forum. "Retail Execution Quality - Overview."

  10. U.S. Securities and Exchange Commission. "Staff Report on Algorithmic Trading in U.S. Capital Markets."

  11. U.S. Securities and Exchange Commission. "SEC Staff Release Report on Equity and Options Market Structure Conditions in Early 2021."

  12. U.S. Securities and Exchange Commission. "Special Study: Payment for Order Flow and Internalization in the Options Market," Part VIII.

  13. U.S. Securities and Exchange Commission. "Staff Report on Equity and Options Market Structure Conditions in Early 2021."

  14. U.S. Securities and Exchange Commission. "SEC Charges Robinhood Financial with Misleading Customers About Revenue Sources and Failing to Satisfy Duty of Best Execution."

  15. Piper Sandler. "eBrokers' PFOF Ramps with Increased Trading; A Review of 2Q20 Rule 606 Reports."

  16. S&P Global Market Intelligence. "SEC unlikely to ban payment for order flow."

  17. U.S. Securities and Exchange Commission. "Special Study: Payment for Order Flow and Internalization in the Options Markets."

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