Payment for Order Flow (PFOF)
What Is Payment for Order Flow (PFOF)?
Payment for order flow (PFOF) is a form of compensation, as a rule in terms of parts of a penny for each share, that a brokerage firm receives for guiding orders for trade execution to a particular market maker or exchange.
Payment for order flow is common in options markets, and is progressively found in equity (stock market) transactions.
Understanding Payment for Order Flow (PFOF)
Equity and options trading has become progressively complex with the multiplication of exchanges and electronic communication networks (ECNs). Albeit the infamous Bernard Madoff was an early practitioner of payments for order flow, the practice is completely legal given the two players to a PFOF transaction satisfy their duty of best execution for the customer starting the trade.
At any rate, that means giving a price no more terrible than the National Best Bid and Offer (NBBO). Brokers are likewise required to document their due diligence procedures guaranteeing the price got in a PFOF transaction was the best that anyone could hope to find from an assortment of alternative order objections.
According to the U.S. Securities and Exchange Commission (SEC), "payment for order flow is a method of transferring a portion of the trading profits from market making to the brokers that route customer orders to experts for execution." The genuine purpose of PFOF transactions is liquidity, not the chance to profit from giving an inferior execution price.
The complexity of executing orders on a huge number of stocks that can be traded on different exchanges has increased market participants' dependence on market makers.
These commonly large firms might work in certain stocks and options, keeping an inventory of shares or contracts and offering to buy as well as sell them. Market maker compensation depends on the spread between the bid and ask prices.
Spreads have been restricting, particularly since exchanges changed from providing share cost estimates in portions to decimals in 2001. That is left market makers progressively dependent on the volume of orders sent their direction and brings given them incentives to the table for PFOF to secure it.
SEC Requirements and PFOF Regulation
Regardless of a brokerage firm's obligation to give a best execution, the SEC has recognized 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 expects brokers to unveil their policies encompassing this practice. They must distribute reports that make sense of their financial associations with market makers, as commanded beginning around 2005 by Regulation NMS.
Your brokerage firm is required to inform you when you first open your account and yearly of payment it receives for sending your orders to specific parties. What's more, brokerage customers can request payment data for specific transactions from their brokers, however it can require a long time to receive a response. Upon request, a firm must unveil each order for which it receives payment.
Refreshes: SEC Rules 605 and 606
According to SEC Rule 605 and Rule 606, broker-dealers are required to make two reports accessible to investors. These reports reveal execution quality and payment for order flow statistics, individually. The SEC ordered these reports in 2005. The format and reporting requirements have changed throughout the long term, with refreshes made in 2018 and then some.
A working group of brokers and market makers made to normalize 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 "don't give the level of information that permits a retail investor to measure how well a broker-dealer normally 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 refreshed in the principal quarter of 2020. The changes required brokers to uncover net payments received every 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 likewise uncover their rate of payment for order flow per 100 shares by order type (market orders, marketable limit orders, non-marketable limit orders, and different orders).
Possible Benefits of PFOF
Smaller brokerage firms that might experience difficulty dealing with large numbers of orders can benefit from routing a portion of those to market makers. Brokers getting PFOF compensation might be forced by competition to give a portion of the proceeds to customers, as lower costs and fees. In any case, such benefits could be reduced assuming PFOF is costing the customers money through inferior execution.
A 2020 SEC report found that PFOF on occasion improved prices for individual investors. Increased liquidity and no-commission trading are other apparent benefits offered by PFOF.
Hidden Fees
Investors unconsciously might be paying fees for their "no-commission" trading. As of late, the SEC communicated concern about orders flowing to the dark market, where the lack of competition among market makers executing trades might mean that brokerages and their customers are being cheated. It is concentrating on whether to reform or bar PFOF.
Reactions of Payment for Order Flow
The practice of PFOF has forever been controversial. A few firms that offered zero-commission trades during the late 1990s routed orders to market makers that didn't keep investors' best interests as a main priority.
This was during the disappearing long stretches of fractional pricing, and for most stocks, the smallest spread was \u215b of a dollar, or $0.125. Spreads for options orders were considerably more extensive. Traders discovered that a portion of their free trades were costing them a lot since they weren't getting the best price at the time the order was executed.
The SEC stepped in and concentrated on the issue top to bottom, zeroing in on options trades. It found, in addition to other things, that the multiplication of options exchanges and the extra competition for order execution restricted the spreads.
Options market makers contended that their services were important to give liquidity. In any case, in its conclusion, the SEC composed:
"While the furious competition brought on by increased numerous posting delivered immediate economic benefits to investors as smaller statements and effective spreads, by certain measures these improvements have been quieted with the spread of payment for order flow and internalization."
One reasoning for permitting PFOF to continue is its part in cultivating competition and limiting the market power of exchanges.
PFOF turned into the subject of restored controversy in 2021, when the SEC report on the retail investor mania for GameStop Corp. (GME) and other image stocks suggested that a few brokerages might 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 appropriately unveil to customers PFOF payments it received for trades that didn't bring about best execution.
Equity PFOF Trends
Richard Repetto, the Managing Director of Piper Sandler and Co., a New York-based investment bank, distributed a report that plunges into the statistics gathered from Rule 606 reports recorded by brokers.
For the second quarter of 2020, Repetto zeroed in on four brokers: Charles Schwab, TD Ameritrade, E*TRADE, and Robinhood. Repetto reported that payment for order flow was fundamentally higher in the second quarter than the first due to increased trading activity. The payment was higher for options than for equities.
The Bottom Line
Expansive, brokers' commission structures have changed. Many offer no-commission equity (stock and exchange-traded fund) orders. Subsequently, payment for order flow has become a major source of revenue.
For the retail investor, the problem with PFOF is that their brokerage may be routing orders to a particular market maker exclusively for its own benefit, and not the investor's.
Investors who trade rarely or in tiny amounts may not feel the effects of their brokers' PFOF practices. Nonetheless, regular traders and the people who trade larger amounts ought to dive more deeply into their brokers' order routing interaction to ensure that they're not losing out on price improvement.
Features
- PFOF has been censured for making possibly unfair or shrewd conditions to the detriment 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.
- 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 a portion of the trading profits from market making to the brokers routing the orders.
- Expected benefits of PFOF might incorporate better execution prices and greater market liquidity.
FAQ
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 sending an order. Brokerage firms' PFOF statistics are read up for possible conflicts of interest, where a brokerage puts its clients' order executions at risk for profit.
Is Payment for Order Flow Good or Bad?
It relies upon who you ask. Some fear that investors fail to get the best accessible execution when their brokers use PFOF. There is concern that profit is a broker's fundamental objective, not a client's best interest. In any case, others contend that PFOF considers zero-commission trading, greater market liquidity, and even orders executed at better prices — which are all benefits for investors.
Is Payment for Order Flow Legal?
Indeed, regardless of being controversial, payment for order flow stays a legal practice, inasmuch as it doesn't include illegal activities like frontrunning and doesn't put the customer in a difficult spot. The SEC has flagged that it plans to return to PFOF as part of its plan beginning in 2022, however market specialists don't expect a ban.
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 keeping an efficient market in which investors' orders can be filled (also called liquidity).
When Did Payment for Order Flow Begin?
While it isn't known for certain when PFOF arrangements originally appeared, the SEC ascribes the rise of payment for order flow to the approach of various options exchanges, starting in 1999, where similar options series could be listed at the same time on more than one exchange. This reality prompted exchanges competing for where options trades ought to be routed, including rebates or incentive payments to the broker or customer for coordinating their order accordingly.
