Payment for order flow

July 27, 2023
10 MIN READ
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Payment for order flow (PFOF) is the pay a broker gets for routing transactions to a certain market maker for execution. Payment for order flow, under the SEC, passes part of the transaction gains from market making to the agents that route the orders. PFOF has been chastised for allegedly inequitable or exploitative arrangements that benefit regular traders and investors. The SEC requires brokerages to tell consumers of any remuneration they get for routing orders to a certain market maker. Better implementation pricing and more market liquidity are two potential benefits of PFOF.

What is payment for order flow?

Payment for order flow (PFOF) is remuneration received by brokers in exchange for making transactions with market participants and electronic communication networks that attempt to perform deals for a small profit. When an agent gets a stock market deal, the transaction is routed via a clearing company. The clearing business ensures that everything between the broker, market participant, and exchange runs well. The market makers execute the deal and pay the brokerage a small percentage of the transaction value as a thank-you for directing trade their way.

The concept of payment for order flow

One of the common stock market misconceptions is that commission-free transactions are free. PFOF is a widespread method in options trading and has become increasingly frequent in stock exchange transactions. Although many commission-free brokerage firms employ PFOF, many ordinary traders are unaware of it. On the other hand, the public has opted not to take PFOF, providing its customers with the opportunity to tip.

Of Ponzi scheme fame, Bernie Madoff invented the PFOF procedure, although his profit-incentivized system has nothing to do with his investing fiasco.

There are two varieties of PFOF, according to Bloomberg contributor Matt Levine: the good/fair model and the bad model;

·       In the fair approach, market participants may receive a fair price on an asset, which benefits all parties involved.

·       However, under the wrong approach, market makers do not acquire the greatest bargain for financiers but rather a fairly acceptable one. Due to this later model, traders scrutinize PFOF rather than accepting it at face value and asking if it represents a price increase or an impasse conflict.

How payment for order flow works

With the growth of markets and electronic communication networks (ECNs), equity and options transaction has grown more sophisticated. Even though the infamous Bernard Madoff was an early adopter of payments for order flow, the technique is fully lawful as long as the two parties to a PFOF transaction satisfy their obligation of best implementation for the client launching the transaction.

That entails offering a lower price than the National Best Bid and Offer (NBBO). Brokers must also disclose their due diligence methods to ensure that the price acquired in a PFOF trade was the most efficient from several potential order destinations.

The SEC of the United States defines payment for order flow as an approach for channeling some of the exchange earnings from market making to the traders who direct orders from clients to experts for implementation. The fundamental goal of PFOF trades is flexibility, not the opportunity to benefit from a lower execution price.  

Because of the intricacy of executing bids on hundreds of equities that might be traded on various exchanges, market players have grown their dependence on market makers. These huge businesses might concentrate on certain equities and options, holding shares or agreements and offering to purchase and sell them. Market makers are paid depending on the spread between price negotiations.

Spreads have been shrinking, particularly since exchanges began posting share prices in decimals rather than fractions in 2001. As a result, market makers have become more reliant on the number of orders coming their way, creating incentives for them to provide PFOF to obtain it. 

PFOF oversight and SEC standards

Regardless of a brokerage company's commitment to offering the best implementation, the SEC has stated that payment for order flow might pose worries regarding whether a company fulfills its responsibility to its client to offer the best performance. Such issues may erode financier trust in the financial sector.

Brokers are required by the SEC to declare their policy on this activity. They must publish disclosures that clarify their financial links with market participants, as required by Regulation NMS since 2005.

When you initially start your account, the broker company must notify you of any payments it gets for transmitting your orders to certain parties. Furthermore, brokerage clients may obtain payment details for individual trades from their brokers. However, this might take weeks. A company must reveal each transaction for which it gets money upon request.

SEC guidelines 605 and 606 amendments

Brokerage firms are obliged by SEC Rules 605 and 606 to create two reports accessible to shareholders. These reports provide information on implementation efficiency and payment for order flow. In 2005, the SEC ordered these disclosures. The structure and reporting requirements have evolved, with revisions occurring in 2018 and afterward.

A committee of brokerage and trading firms formed to harmonize the implementation of order quality reporting has shrunk to only one retail broker (Fidelity) and one market maker (Two Sigma Securities).

According to the Financial Information Forum, Rule 605 and Rule 606 report that they should not offer the degree of data that permits a typical trader to evaluate how effectively a brokerage firm normally fills a retail order when in comparison to the 'national best bid or offer' (NBBO) at the period the implementing broker-dealer accepted the order.

The specifications of Rule 606 were modified in the first trimester of 2020. Brokers were obliged to report net compensation received from market makers for deals performed in S& P 500 and non-S& P 500 equities trading and options transactions under the revisions. Brokerages must publish their order flow payment rate per 100 shares, broken down by the kind of order (marketable limit orders, non-marketable limit orders, market orders, and others). 

Possible advantages of PFOF

Modest broker companies struggling to handle huge orders might profit by directing some of them to market makers. Brokers that get PFOF reimbursement may be required to pass on the part of the revenues to consumers through decreased charges due to competition. Yet, such advantages may be negated if PFOF loses clients' money due to poor implementation.

According to a 2020 SEC report, PFOF sometimes provides better rates for individual shareholders. Other alleged benefits of PFOF include higher liquidity and no-commission dealing. Nevertheless, traders may be unintentionally paying costs for "no-commission" transactions. The SEC has raised worry about orders migrating to the black market, where the absence of competition among market participants executing transactions may result in brokers and their clients being overcharged. It is considering whether to modify or prohibit PFOF.

Detractors of payment for order flow

PFOF has long been a contentious procedure. During the end of the 1990s, certain businesses that promised zero-commission trading directed orders to market players who did not always act in the most beneficial interests of financiers.

In the latter days of fractionated pricing, the narrowest spread for most shares was 1/8 dollars, or $0.125. Spreads on options transactions were much wider. Investors noticed that some trade liberalizations were losing significant money since they were not obtaining the best price when the order was completed. 

The SEC intervened and thoroughly investigated the matter, focusing on options trading. It discovered, among other things, that the development of options exchanges and increased competition for order execution reduced spreads.

 One justification for retaining PFOF is its function in creating competition and restraining exchange market dominance.

In 2021, the SEC report on typical traders' frenzy for GameStop Corp. (GME) and other meme stocks stated that certain brokerages might push their clients to trade to benefit from PFOF. The SEC penalized Robinhood Markets Inc. (HOOD) $65 million in December 2020 for not adequately disclosing to consumers PFOF fees for transactions that failed to result in optimal execution. The options market participants said that their operations were required to offer stability.

Changes in equity PFOF

Piper Sandler & Co.'s Managing Director, Richard Repetto, produced a paper that delves into the information collected from Rule 606 brokerage disclosures. Repetto centered around four intermediaries in the second trimester of 2020: Charles Schwab, TD Ameritrade, E*TRADE, and Robinhood. Because of increased trading volume, Repetto claimed that payment for order flow was much greater in the second quarter than in the first. The payout for options was greater than for shares.

Why does the general public not utilize PFOF?

The public discontinued collecting payment for order flow to avoid an impasse conflict. Rather, we have included tipping, which allows us to concentrate on developing an environment we trust.

Transactions are free of commission, and gratuity is voluntary. Participants of the Public.com forum can leave a tip to assist in covering the cost of transaction execution. We can direct every transaction order straight to exchanges (e.g., Nasdaq and NYSE) or various platforms where PFOF is not involved in the implementation procedure with the assistance of our clearing partner, Apex.

Because direct routing to the exchanges is more costly, we are converting what was formerly a revenue stream (ahem—PFOF) into a cost center. In addition, avoiding PFOF helps us to promote our fundamental principles of a transparent investment environment since the practice may work against the positive effect that many investors picture when they imagine a better future. Other revenue streams for the public include interest on cash balances, Premium memberships, stock lending, and other charges and alliances.

How does PFOF affect investors?

Traders are raising the standards for brokers these days, requesting openness in business methods so they can see how firm profits from them and the degree to which they like it.

The opposition to paying for order flow demonstrates that we do not have to accept stock market rules at face value. Traders using the Public app may tip themselves or save cash while performing deals directly with the market. The same cannot be stated for all no-fee intermediaries, although this may change.

Should you use a trading program that sells the transaction orders?

Proper research is more than just examining the efficiency of a company. It also entails delving deeply into your broker. Investors should know if their broker employs PFOF and sells their trade orders to a market operator.

If they earn from PFOF, do they possess procedures to guarantee they are acting in the best interests of the shareholders? It is tough to demonstrate, so an increasing number of merchants are choosing a PFOF-free marketplace. Is there any other method to provide monies to the market operators who make all these transactions possible without PFOF?

Because of this, the public does not employ PFOF. Instead, it relies on tips to assist in paying for conducting market orders, allowing us to eliminate the disparity between our broker and the clients we serve. We provide ethical investment in addition to being PFOF-free. Members of our network may follow their peers and domain specialists to discover what they are investing in, discuss ideas, and improve their knowledge of finance.

Market maker

A market maker (MM) is a person or financial business actively trades in particular securities. Market makers are critical to establishing an effective marketplace where orders from investors may be completed (also known as liquidity).

Is it legal to pay for order flow?

Despite its contentious nature, paying for order flow is lawful as long as it does not entail criminal activity like front-running and does not place the client at a significant disadvantage. The SEC has indicated that PFOF would be revisited as a component of its agenda starting in 2022, although market analysts do not expect a prohibition.

Conclusion

Broker commission arrangements have shifted throughout the industry. Many brokers provide no-commission equities (stock and ETF) orders. Consequently, payment for order flow has emerged as a significant source of income. The issue with PFOF for the individual investor is that their broker may direct orders to a certain market operator exclusively for its gain rather than the customers. The financiers who trade rarely or in modest amounts may be unaffected by their intermediaries' PFOF activities. Nevertheless, regular investors and those who trade in larger amounts should understand their brokerages' order routing method to avoid missing out on price increases.