What is payment per order flow (PFOF)?
Payment per order flow (PFOF) is the compensation and profit a brokerage firm receives for directing orders to different parties for the execution of trades. 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 trading, the market is dominated by market makers, as each optional share could have thousands of possible contracts. Payment for order flow is basically ubiquitous for option transactions and averages less than $ 0.50 per contract traded.
- Payment per order flow (PFOF) is the compensation a broker receives for routing trades for the execution of trades.
- “Payment for order flow is a method of transferring some of the trading profits from market making to brokers who send client orders to specialists for execution,” the SEC said in a study.
- Some have criticized PFOF for creating unfair or opportunistic conditions at the expense of traders and retail investors.
Understanding payment per order flow
Trading stocks and options has become increasingly complex with the proliferation of exchanges and electronic communication networks (ECNs). Ironically, payment per order flow is a practice started by Bernard Madoff, the very Madoff of the Ponzi scheme notoriety.
The Securities and Exchange Commission (SEC) said, in a special study in PFOF published in December 2000, “Payment per order flow is a method of transferring some of the trading profits from market making to brokers who submit client 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 companies that specialize in a number of stocks and options, that maintain an inventory of stocks or contracts, and offer them to both buyers and sellers. Market makers are compensated based on the spread between bid and ask prices. Spreads have narrowed, especially since trades went 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.
Breakdown of the initial payment for the order flow
In a particular pay-per-order flow scenario, a broker receives fees from a third party, sometimes without the customer’s knowledge. This naturally invites conflicts of interest and subsequent criticism of this practice. Currently, the SEC requires brokers to disclose their policies around this practice and to publish reports that disclose their financial relationships with market makers, as required by the 2005 NMS Regulation. The SEC requires that your brokerage firm report if you get paid to ship your orders to specific parties. You must do this when you first open your account, as well as annually. The company must also disclose whether it participates in the payment of the order flow and, upon request, all the orders in which it receives payment. Brokerage clients can therefore request payment details from their brokers on specific transactions, although the response usually takes weeks.
Cost savings from paying for order flow arrangements should not be overlooked. Smaller brokerage firms, unable to handle thousands of orders, can benefit from routing orders through market makers and receiving compensation. This allows them to send their orders to another company to be bundled with other orders to be executed and can help brokerage firms keep their costs down. The market maker or stock market maker benefits from the additional share volume it handles, thereby compensating brokerage firms for driving traffic. Investors, particularly retail investors, who often lack bargaining power, could possibly benefit from competition to fulfill their order requests. However, as with any gray area, arrangements to run business in one direction invite wrongdoing, which can undermine investor confidence in financial markets and their players.
Criticisms of payment by order flow
Throughout its existence, the practice has been mired in controversy. There were several companies offering commission-free trading in the late 1990s that sent orders to market makers who did not see in the best interests of investors. This was during the last few days of split pricing, and for most stocks, the smallest spread was ⅛ of a dollar, or $ 0.125. Spreads for option orders were considerably wider. Merchants found that some of their “free” trades were costing them quite a bit, as they weren’t getting the best price at the time the transaction took place.
That’s when the SEC stepped in and studied the issue in depth, concentrating on options trading, and almost concluded that PFOF should be illegal. The study found, among other things, that the proliferation of option exchanges reduced spreads as there was additional competition to execute orders. The creators of the options market argued that their services were necessary to provide liquidity. In its conclusion, the report stated: “While the fierce competition caused by the rise in multiple quotes produced immediate economic benefits for investors in the form of tighter quotes and effective spreads, by some measures, these improvements have lessened over time. distribution of payment by flow of orders and internalization “.
Part of the decision that allows the practice to continue is the potential for exchanges to develop monopoly power, so the SEC allowed payment for order flow to continue just to improve competition. There was also some confusion about what would happen to exchanges if the practice were banned. The SEC decided to require brokers to disclose their financial agreements with market makers. The SEC has trained an eagle eye in practice ever since.
Payment for changes in order flow in 2020
If you search a broker’s website, you can find two reports, labeled Rule 605 and Rule 606, They show the quality of execution and payment of the order flow statistics. These reports can be nearly impossible to find despite the fact that the SEC requires stockbrokers to make them available to investors. The SEC mandated these reports in 2005, although the reporting format and 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 the reporting of the quality of order execution that has been narrowed down to a single retail broker (Fidelity) and a single market maker (Two Sigma Values). FIF notes that the 605/606 reports “do not provide the level of information that allows a retail investor to measure how well a broker-broker generally fills a retail order compared to the ‘national best offer or offer’ (NBBO) at the time that the order was received by the executing stockbroker. ”
The 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 stock trades, as well as trades of options. Brokers must also disclose the order flow pay rate received for every 100 shares by order type (market orders, tradable limit orders, non-tradable limit orders, and other orders).
Richard Repetto, Managing Director of Piper Sandler & Co., a New York-based investment bank, publishes a report that delves into the statistics gleaned from Rule 606 reports submitted by brokers. For the second quarter of 2020, Repetto focused on four brokers: Charles Schwab, TD Ameritrade, E * TRADE, and Robinhood. Repetto reported that the payment for order flow was significantly higher in the second quarter than the first due to increased trading activity and that the payment was higher for options than for stocks.
Repetto says the PFOF received showed increases across the board. Schwab continues to receive the lowest rates, while TD Ameritrade and Robinhood received the highest rates for the options. Additionally, Robinhood received the highest rate for shares. Repetto assumes that Robinhood’s ability to charge a higher PFOF is potentially reflected in the profitability of its order stream and that Robinhood receives a fixed rate for margin (versus a fixed rate per share from the other brokers). Robinhood saw the largest quarter-over-quarter increase in PFOF in both stocks and options of the four brokers detailed by Piper Sandler, as their implied volumes also increased the most. All four brokers saw an increase in fees received for the PFOF option.
TD Ameritrade took the biggest hit on revenue by cutting their trade commissions in Fall 2019, and this report shows that they are apparently trying to make up for that shortfall by shipping orders for additional PFOF. Robinhood has refused to disclose its business statistics using the same metrics as the rest of the industry, but offer a vague explanation in your supporting articles.
The bottom line
With industry-wide changes in broker commission structures, offering commission-free capital orders (exchange-traded funds and stocks), pay-per-order flow has become a major source of income. For the retail investor, however, the problem with pay per order flow is that the brokerage could be placing orders to a particular market maker for their own benefit and not in the best interest of the investor.
Investors who trade infrequently or in very small amounts may not feel the effects of their brokers’ PFOF practices. But frequent traders and those who trade large quantities should learn more about their broker’s order routing system to ensure that they are not missing out on price improvement due to a broker prioritizing payment over order flow.