Payment for order flow

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Payment for order flow (PFOF) is the compensation, as much as 1 penny per share, that a stockbroker receives from a market maker in exchange for the broker routing its clients' trades to that market maker.^[1] It is a controversial practice that has been called a "kickback".^[2]

In general, market makers are willing to pay brokers for the right to fulfill small retail orders. The market maker makes a profit from the bid-ask spread and rebates a portion of this profit to the routing broker as PFOF. Another fraction of a penny per share may be routed back to the consumer as price improvement.^[3][4] Brokers in the United States that accept payment for order flow include Robinhood, E-Trade, Ally Financial, Webull, Tradestation, The Vanguard Group, Charles Schwab Corporation, and TD Ameritrade, while brokers that do not receive payment for order flow include Interactive Brokers (pro accounts that are charged commissions), Merrill Edge, and Fidelity Investments.^[5]

In the United States, accepting PFOF is only allowed if no other exchange is quoting a better price on the National Market System. The broker must disclose to the client that it accepts PFOF. Transactions must be executed at the best execution, which could mean the best price available or the speediest execution available.^[1]

PFOF is not allowed in Canada^[3] and therefore Canadian brokers charge commissions.^[6] It is also banned in the United Kingdom.^[3][7]

History[]

PFOF was pioneered by Bernie Madoff. In a 2000 interview, he described it as a way for market makers to outsource the task of finding orders to fulfill, and compared it to retail arrangements in which a supplier pays for the rack on which its products are displayed.

"No one tells a firm how they can advertise. If I want to hire salesmen to generate order flow, no one is going to object. I don’t have them. So if I want to use Fidelity's salesmen and pay part of my trading profits in the form of a rebate, why shouldn’t I be allowed to do it? It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated."
    -Bernie Madoff^[2]

In the U.S., when stocks traded in 1/8 of a dollar increments, payments for order flow were much larger than they became after the tick size fell to one cent.^[4]

In 2014, the United States Senate Homeland Security Permanent Subcommittee on Investigations, led by Carl Levin, conducted hearings focused on the conflicts of interest inherent in PFOF.^[8] At the hearings, an executive for TD Ameritrade said that it routes orders to wherever it can get the highest payment.^[9]

In his 2014 book, Flash Boys, Michael Lewis called PFOF a "wacky incentive".^[4]

In 2020, PFOF received by TD Ameritrade, Charles Schwab Corporation, E-Trade, and Robinhood totaled $2.5 billion.^[10]

In 2021, after the GameStop short squeeze, officials again questioned whether retail traders were getting the best possible prices on their orders.^[11]

Analysis[]

Conflicts of interest[]

Payment for order flow has been described as a conflict of interest.^[12] PFOF can cause orders that are executable to not get executed as they are routed to market makers that pay the highest amount. Retail traders generally have less information than institutions (adverse selection).^[13]

Lower commissions and fees, price improvement[]

Since retail orders have a lower chance of adverse selection for the market maker, they are more profitable for the market maker. These savings are passed on in part to the broker as PFOF, but also to the retail customer as price improvement: market makers often fill retail orders at a better price than the best price available on public exchanges. The additional revenue for brokers allows them charge minimal commissions.^[14] PFOF was a key factor in elimination of most brokerage commissions in the United States.^[15]

Increase in market liquidity and competition[]

Madoff claimed that PFOF increases market liquidity and thus reduces the bid–ask spread.^[11] He also claimed that by routing orders away from the New York Stock Exchange, PFOF increased competition.^[16]

References[]