What Is Payment for Order Flow (PFOF) And How Can It Affect Traders?
Payment for Order Flow (PFOF) is a concept which was brought to the forefront with the recent Gamestop and Reddit stories.
Since most traders in financial markets need brokers to purchase or sell securities on certain exchanges, these brokerage firms are responsible for routing orders from traders to exchanges. Payment for Order Flow (PFOF) is the compensation received by broker from the market maker for routing these trades to them.
PFOF isn’t something that most retail traders will worry about and it might even be considered a good thing, since it gives them access to cheaper or even commission-free trading. That being said, there is a lot of suspicion surrounding PFOF, and it’s actually banned in multiple countries, such as Canada, the United Kingdom, and certain jurisdictions within Europe.
If you are a trader that uses a PFOF broker in the US or Europe, or you are just curious about the topic in general, then read on. We’ll cover the basics of Payment for Order Flow in this article.
What Is Order Flow?
Order flow is essentially the flow of orders sent, modified and canceled, which interact with other orders and result in executed transactions or trades. This is order flow, and the behavior of others order interactions is dictated by market microstructure.
It can be different for different markets, but usually when a trader sends an order, it is sent to the exchange via their broker. If the order is executed against another order on the exchange, then the trade is complete and this will be reflected in their live PnL and brokerage statement.
How Payment For Order Flow Works
For every trade executed, the brokers get a fraction of its value for routing the order to exchanges on the financial markets.
There are two points to this.
- Broker Receives Fees
Traders in a financial market execute their trades with the help of brokers. These brokers receive a specific fee for placing orders and executing them on behalf of traders. This fee is usually a fixed amount or a percentage of the value of the trade, and in the case of PFOF, they also receive fees from market makers.
- Regulatory Body Requirements
In the US, the SEC has laid out specific requirements to be fulfilled. Firstly, the brokers must disclose the fees being taken from the traders to the SEC. The brokers must also disclose their practice policies and relationship with the market makers. This is relevant to the US only and may be slightly different in other jurisdictions.
The Pros and Cons of PFOF
Although PFOF is viewed with suspicion by many traders, the reality is not so simple. In many ways, PFOF gives a few benefits to traders, especially retail. However, for those worried about potential manipulative practises, it may be better to simply pay commissions and avoid PFOF broekrs altogether.
Here are 2 pros and 1 con of PFOF.
- Pro: Cheaper Trading
Payment for Order Flow allows the brokers to earn revenue without charging high brokerage commissions, therefore reducing the cost incurred by traders. This opens up trading to the broader public—it “democratizes” finance. If used wisely, it can also increase the profitability of traders, since it greatly reduces the number one cost of trading.
- Pro: Increased Market Liquidity
In 2020, a report by the SEC found that PFOF increased liquidity and even sometimes offered better prices for individual traders and investors. Since these orders are sent directly to market makers that provide liquidity to the market, it can result in lower spreads. Although this is debated by some, and this specific argument is difficult to prove one or another.
- Con: Conflicts of Interest
Payment for order flow can create a conflict of interest as sometimes the order may get executed at a worse price than if it was executed by a different market maker. This can occur because the order is routed from the broker to the market maker that payed the most for this order flow, and they have an inventory to manage. If a trade or batch of trades would cause an adverse outcome for their book, they may change the bid-ask spread to a less favorable one for those particular trade/s.
Most Famous PFOF and Non-PFOF Brokers
If PFOF is important to you and you decide to trade (or avoid) a PFOF broker, then here is a list of the most popular brokers that use PFOF (in the US).
Robinhood is a trading and investment platform that allows traders to purchase or sell securities, including complex derivatives like options via PFOF brokers. It is focused on millennial investors and provides the opportunity to invest in multiple financial markets. Robinhood is a good choice for beginners and is popular because of its zero-commission model.
TD Ameritrade is a trading platform that allows traders to invest in different types of securities. It incorporates PFOF brokers for some securities but not all. It is a comprehensive and easy-to-use platform for beginners and active users.
E*Trade is one of the earliest platforms for trading securities in the United States. It incorporates a web-based and application-based platform for traders to invest in securities. E*Trade provides a lot of educational resources which can be helpful for traders utilizing the platform.
Schwab, also known as Charles Shwab, is an online trading platform for investing in securities across various financial markets. It is one of the most popular trading platforms for beginners and active users.
If you wish to avoid PFOF, then brokers that don’t sell order flow include Interactive Brokers (pro accounts), Merrill Edge, Fidelity Investments, and Public.com.
Payment for Order Flow has become a hot topic once again after the recent Gamestop and Reddit stories. PFOF provides the trader with a highly liquid market and cheaper rates for trading. However, it can also result in conflicts of interest between market makers and brokers. Therefore, traders must think carefully about PFOF before deciding for or against a PFOF broker.
Bookmap is not a broker but a trading platform that you can connect your broker or exchange to, seeing all the order flow available under the hood. You can try it out for free today. Click here to get started.