What Is Payment for Order Flow (PFOF)?

Payment for order flow (PFOF) is a method of compensating brokers for routing trades to a specific market maker. Brokers are required by the SEC to inform clients of the compensation they receive for routing their orders. While PFOF has been criticized for potentially creating unfair conditions, it may also offer advantages such as better execution prices and greater market liquidity.

Basics

Compensation through payment for order flow involves brokerage firms receiving fractions of a penny per share as remuneration for routing trade execution orders to specific market makers or exchanges. This practice is prevalent within options markets and is progressively extending to equity (stock market) transactions.

Deciphering Payment for Order Flow (PFOF) in Modern Trading 

The landscape of equity and options trading has evolved into a complex web of exchanges and electronic communication networks (ECNs). While Bernard Madoff once dabbled in payments for order flow, the legality of this practice stands firm, contingent upon both parties in a PFOF transaction upholding their obligation for optimal execution for the initiating trade.

Essentially, this entails ensuring a price at least as favorable as the National Best Bid and Offer (NBBO). Brokers also must meticulously document their diligent processes, confirming that the price attained through a PFOF transaction prevails as the finest among various alternative order avenues.

The U.S. Securities and Exchange Commission (SEC) denotes payment for order flow as a mechanism shifting some trading gains from market making to brokers directing customer orders to specialists for execution. The primary intent of PFOF transactions is fostering liquidity, not exploiting a subpar execution price.

Navigating the intricacies of executing orders across numerous stocks on multiple exchanges has led market participants to increasingly rely on market makers. These prominent entities often focus on specific stocks and options, maintaining a stockpile of shares or contracts and facilitating both buying and selling. Market maker remuneration hinges on the spread between bid and ask prices.

Given the tightening spreads, particularly since the shift from fractional to decimal share pricing in 2001, market makers have found themselves leaning on order volume and, consequently, embracing PFOF to ensure a steady stream.

SEC Guidelines and PFOF Oversight 

The SEC acknowledges that payment for order flow may impact a brokerage firm's best execution duty to customers, potentially eroding investor confidence in the financial markets. To enhance transparency, brokers are mandated by Regulation NMS since 2005 to divulge their financial relationships with market makers through regular reports. Clients are informed about PFOF upon account opening and annually, and they can request payment data for specific transactions.

In accordance with SEC Rule 605 and Rule 606, broker-dealers are obligated to provide two reports: one detailing execution quality and the other presenting payment for order flow statistics. These reports, initiated in 2005 and updated in 2018, offer insights into order execution but fall short of providing a comprehensive comparison with the 'national best bid or offer' (NBBO).

The Rule 606 update of Q1 2020 stipulated that brokers disclose monthly net payments from market makers for S&P 500 and non-S&P 500 equity trades, along with options trades. Brokers are also required to reveal payment for order flow rates per 100 shares, categorized by order type.

Exploring Potential Gains From PFOF 

For smaller brokerages grappling with high order volumes, redirecting some to market makers can prove advantageous. PFOF compensation received by brokers might prompt them to share a portion with clients, thereby reducing costs. The benefits may lose their value if poor execution undermines the progress made.

A 2020 SEC analysis revealed improved prices for individual investors through PFOF. Augmented liquidity and fee-free trading further highlight the purported merits of PFOF.

Unbeknownst to investors, purported "no-commission" trading might involve hidden fees. Recently, the SEC raised concerns about orders flowing into the dark market, where limited competition among executing market makers could potentially lead to overcharging of brokerages and their clients. The possibility of reforming or prohibiting PFOF is currently under the SEC's scrutiny.

Critiquing Payment for Order Flow Practices 

PFOF has consistently stirred debate due to concerns surrounding investor interests. In the late 1990s era of zero-commission trades, certain firms directed orders to market makers who disregarded investors' optimal interests.

During the era of fractional pricing, typically amounting to 1/8 of a dollar ($0.125), for most stocks, the narrowest spread prevailed. Options orders faced notably broader spreads. Traders realized that seemingly free trades incurred substantial costs, as they missed out on favorable execution prices.

In response, the SEC conducted an in-depth study, primarily focusing on options trades. Its findings indicated that the proliferation of options exchanges and intensified order execution competition contributed to narrower spreads. 

Options market makers contended that their services played a pivotal role in sustaining liquidity. However, the SEC's assessment ultimately noted:

"While heightened competition stemming from increased multiple-listing yielded immediate economic advantages through reduced quotes and effective spreads, the proliferation of payment for order flow and internalization has somewhat tempered these enhancements." 

One argument for allowing PFOF to persist lies in its function as a competition stimulant, curbing the dominance of exchanges.

The year 2021 witnessed renewed PFOF controversy. The SEC's report on the retail investor surge involving GameStop Corp. (GME) and other meme stocks hinted at brokerages potentially encouraging customer trades for PFOF gains. 13 In December 2020, Robinhood Markets Inc. (HOOD) faced a $65 million SEC fine for inadequately disclosing PFOF payments received for trades not achieving optimal execution.

Analysis of Equity PFOF Patterns 

An insightful examination emerges from the report by Richard Repetto, the Managing Director of Piper Sandler & Co., an investment bank headquartered in New York. This study delves into statistics drawn from brokers' Rule 606 filings.

The second quarter of 2020 witnessed Repetto's scrutiny of four brokers: Charles Schwab, TD Ameritrade, E*TRADE, and Robinhood. Notably, the payment for order flow exhibited a substantial surge in the second quarter compared to the preceding one, attributed to escalated trading activity. Notably, payments were more pronounced for options than equities.

Conclusion

Impact Across the industry, commission frameworks within brokerages have undergone significant transformations. Numerous entities now provide commission-free options for equity (stock and exchange-traded fund) orders. Consequently, payment for order flow has emerged as a prominent revenue stream.

For retail investors, a critical concern surrounding PFOF is the potential misalignment between their brokerage's order routing and the investor's interests. The risk lies in orders being directed to a specific market maker primarily for the brokerage's gain rather than prioritizing the investor's benefit.

Less active or smaller-scale traders might not immediately sense the ramifications stemming from their brokers' PFOF strategies. However, for frequent traders or those engaging in larger trades, delving into their brokers' order routing procedures becomes imperative. This proactive approach ensures that they do not inadvertently miss out on favorable price enhancements.