What Is Payment for Order Flow?
Payment for order flow (PFOF) is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. Equity and options trading has become increasingly complex with the proliferation of exchanges and electronic communication networks (ECNs). Ironically, payment for order flow is a practice pioneered by Bernard Madoff — the same Madoff of Ponzi scheme notoriety. The SEC says, in a special study on the topic published in December 2000, “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.”
Given the complexity of executing orders on thousands of stocks that can be traded on multiple exchanges, the practice of being a market maker has grown. Market makers are typically large firms that specialize in a set number of stocks and options, maintaining an inventory of shares or contracts and offering them both to buyers and sellers. Market makers are compensated based on the spread between the bid and ask prices. Spreads have been narrowing, especially since exchanges transitioned from fractions to decimals in 2001. A key to profitability for a market maker is the ability to play both sides of as many trades as possible.
The brokerage firm receives a small payment, usually fractions of a penny per share, as compensation for directing the order to a particular market maker. For options trades, the market is dominated by market makers since each optionable stock could have thousands of possible contracts in existence. Payment for order flow is basically ubiquitous for options transactions and averages approximately $0.40 per contract traded.
Breaking Down Payment For Order Flow
In a particular 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, the SEC requires brokers to disclose their policies surrounding this practice, and publish reports that disclose their financial relationships with market makers, as mandated in 2005’s Regulation NMS. 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. Brokerage customers can request payment data from their brokers on specific transactions, though the response usually takes weeks.
The cost savings from payment for order flow arrangements shouldn't be overlooked. Smaller brokerage firms, which can't handle thousands of orders, can benefit from routing orders through market makers and receiving compensation. This allows them to send off their orders to another firm to be bundled with other orders to be executed and can help 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. Investors, particularly retail investors, who often lack bargaining power, can possibly 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.
Controversy Surrounding Payment for Order Flow
During its existence, the practice is shrouded in controversy. There were several firms offering zero-commission trades during the late 1990s who were routing orders to market makers that did not look out for the investors’ best interests. 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 since they weren’t getting the best price at the time the transaction was placed.
That’s when the SEC stepped in and studied the issue in-depth, focusing on options trades, and nearly concluded that PFOF should be outlawed. The study found, among other things, that the proliferation of options exchanges narrowed the spreads since there was additional competition for executing orders. Options market makers argued that their services were necessary in order to provide liquidity. In its conclusion, the report stated, “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.”
Part of the decision permitting the practice to continue is the possibility of exchanges developing monopoly power, so the SEC permitted payment for order flow to continue just to enhance competition. There was also some confusion over what would happen to trades should the practice be outlawed. The SEC decided to require brokers to disclose their financial arrangements with market makers. The SEC has trained an eagle eye on the practice ever since.
Payment For Order Flow in 2020
If you dig around a broker’s website, you may find two reports, labeled Rule 605 and Rule 606, which display execution quality and payment for order flow statistics. These reports can be nearly impossible to find in spite of the fact that the SEC requires broker-dealers to make them available to investors. The SEC mandated these reports in 2005, though the format and reporting requirements have changed over the years with the most recent updates made in 2018. A group of brokers and market makers created a working group with the Financial Information Forum (FIF) that attempted to standardize reporting of order execution quality that has dwindled to just a single retail brokerage (Fidelity) and a single market maker (Two Sigma Securities). FIF notes that the 605/606 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 reporting was changed in the first quarter of 2020, requiring brokers to provide 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 the rate of payment for order flow received per 100 shares by order type (market orders, marketable limit orders, non-marketable limit orders, and other orders).
Richard Repetto, the Managing Director of Piper Sandler & Co., a New York-based investment bank, publishes a report that dives into the statistics gleaned from Rule 606 reports filed by brokes. For the 2nd 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 2nd quarter than the first due to increased trading activity and that the payment was higher for options than for equities.
Quarterly Payment for Order Flow Received by Security Type, 2020
Repetto says that PFOF received showed increases across the board. Schwab continues to receive the lowest rates while TD Ameritrade and Robinhood received the highest rate for options. In addition, Robinhood received the highest rate for equities. Repetto assumes that Robinhood's ability to charge higher PFOF is potentially reflected in the profitability of their order flow and that Robinhood receives a fixed rate per spread (vs. a fixed rate per share by the other brokers). Robinhood experienced the greatest quarter-over-quarter increase in PFOF in both equities and options of the four brokers detailed by Piper Sandler as their implied volumes increased the most as well. All four brokers saw an increase in the rates received for option PFOF.
TD Ameritrade took the biggest income hit when cutting their trading commissions in fall 2019, and this report shows that they are apparently trying to make up that shortfall by routing orders for additional PFOF. Robinhood has refused to disclose their trading statistics using the same metrics as the rest of the industry, but they offer a vague explanation in their support articles.
With the industry-wide changes in brokers’ commission structures, offering no-commission equity (stock and exchange-traded fund) orders, payment for order flow has become a major source of revenue. For the retail investor, though, the problem with payment for order flow is that the brokerage might be routing orders to a particular market maker for their own benefit, and not in the investor’s best interest.
Investors who trade infrequently or in very small quantities may not feel the effects of their broker’s PFOF practices. But frequent traders and those who trade larger quantities should learn more about their broker’s order routing system to make sure that they’re not losing out on price improvement due to a broker prioritizing payment for order flow.