Payment for order flow consists of a “kickback” or commission that the broker routing customers to a market maker (in charge of enabling the bid and ask price) will pay a commission to the broker as a sort of market-making fee.
How does the payment for order floe work?
In an interview to Bernie Madoff back on May 2000, asked why his firm was “paying brokerages to ship trades your way” Madoff explained:
It’s a relatively small part, maybe 20 percent, of our business today. Payment for order flow was only an issue as it related to best execution. Does inducing someone to send an order to you present a problem as far as getting the right price goes? Quite honestly that depends on the firm. You’re all fiduciaries. As long as you operate in the proper fiduciary capacity, and you’re dealing with a reputable firm, it wasn’t a problem.
At the question “Will payment for order flow ever disappear?” Madoff replied:
No. I think it will get lower and lower as the spreads get lower and lower with decimals. 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.
|Definition||Payment for Order Flow (PFOF) is a practice in financial markets where brokerage firms receive compensation from market makers or trading firms in exchange for directing customer orders to them for execution. It involves routing customer orders to external parties rather than executing them within the brokerage.|
|Origin||Payment for Order Flow began in the United States in the 1980s as a response to commission deregulation. It aimed to provide brokerage firms with an additional revenue stream by selling order flow to market makers. The practice gained popularity as electronic trading became more prevalent.|
|Implications||– Conflicts of Interest: PFOF raises concerns about potential conflicts of interest, as brokers may prioritize payment over obtaining the best execution for their customers. – Market Liquidity: PFOF can contribute to market liquidity as it encourages market makers to trade with retail orders. – Commission Reduction: It has allowed brokers to offer commission-free trading to retail investors.|
|Examples||– Robinhood: The popular online brokerage has faced scrutiny for its reliance on PFOF as a revenue source. – Market Makers: Firms like Citadel Securities and Virtu Financial are examples of market makers that pay for order flow.|
|Regulation||PFOF is regulated by financial authorities such as the U.S. Securities and Exchange Commission (SEC). Regulations require brokers to disclose their PFOF practices and ensure best execution for customer orders.|
|Benefits||– Commission-Free Trading: Retail investors often benefit from commission-free trading, thanks to PFOF. – Brokerage Revenue: Brokerage firms generate income through PFOF, which can support their business models. – Market Efficiency: PFOF can contribute to tighter bid-ask spreads and increased market liquidity.|
|Concerns||– Conflicts of Interest: Brokers may have an incentive to route orders to the highest bidder, potentially compromising customer interests. – Execution Quality: Some argue that PFOF could lead to suboptimal execution for retail traders. – Lack of Transparency: Critics say that the practice lacks transparency, making it hard for customers to assess its impact.|
|Recent Developments||In early 2021, the GameStop trading frenzy drew significant attention to PFOF and market dynamics. This led to discussions and regulatory scrutiny regarding the practice’s impact on market integrity and investor protection.|
The Robinhood Saga
The payment for order flow issue got a major interest in 2021, as meme investors targeted various stocks, and some of them were backed by hedge funds, which were squeezed out.
Robinhood stopped trading these stocks, and the suspect from some was that the platform was acting in favor of these players instead of its retail investors. And some claimed this might be due to the fact Robinhood earns money also through payments for order flow.
Indeed, brokerage firms like Robinhood pass along their customers’ trades to other market makers are compensated on top of the spread between the bid and ask price with a fee for each trade as a “market maker fee” (the largest market maker for options in the US is called Citadel Securities – owned by Citadel LLC, which during the short squeeze from Redditors bailed out the hedge fund Melvin Capital).
Understanding The Issue
In general, the Rule prohibits market participants from displaying, ranking, or accepting quotations, orders, or indications of interest in any NMS stock priced in an increment smaller than $0.01 if the quotation, order, or indication of interest is priced equal to or greater than $1.00 per share.
As Robinhood’s CEO highlighted:
Back in 2005, when Rule 612 was adopted, the consensus was that price increments of $0.0001 were economically insignificant. Supporters of the rule argued that sophisticated investors may use these smaller increments to step ahead of retail investors by trivial amounts. Some also argued that technology hadn’t advanced enough to properly handle an enormous increase in on-exchange quoting.
Connected Financial Concepts
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