What Is Payment For Order Flow and Why is it so Controversial?

Whether you want to ride in the front seat of a crowded car or grab the last piece of cake, most of us are familiar with what we call “first dibs” or the like to get the first shot at something before anyone else .

Although it may seem a bit counterintuitive, the same goes for stock market operations. This is called Payment of order flowand you’ve probably been a part of it whether you realize it or not.

“Paying for order flow” is an industry term for calling first dibs on a stock trade. For this, very sophisticated computer programs link to participation brokers and large stock exchanges to decide which trades go where, and trading firms are willing to pay to be so connected. Learn more about how it works, how it affects your portfolio, and other details you should know as an exchange participant.

What is Payment for Order Flow (PFOF)?

Order flow payment (PFOF) refers to a practice where a stockbroker receives compensation for routing an order to a particular market maker. In other words, it means that your broker gets paid to process your trades through a certain third party.

When you normally place a trade, your broker works with a clearing program to route the order. This ensures that your order is processed correctly and that the correct trade information flows between the broker, the market maker and the exchange.

This can be a complex concept to understand, so here’s an example:

Let’s say you want to sell 100 shares of Stock X, so you log into your stock trading or brokerage application and enter an order to sell 100 shares. If your brokerage participates in PFOF, the sale may not go directly to the New York Stock Exchange or Nasdaq. Instead, a brokerage firm will quickly analyze the transaction to decide whether it can profit from the order by handling the trade by himself.

If someone else wants to buy 100 shares of Stock X and their brokerage uses the same broker for order flow, the middle firm he could intercept the trade, run the trade on his own and make a small profit. This order never goes through a major exchange. The middle company shares a portion of this profit with the participating brokerages that enter your trade into their system.

As you can probably see, this presents a potential conflict of interest. This is because with PFOF, your broker receives compensation for routing your order to a specific market maker, which may not always be in your best interest.

Payment history for order flow

Paying order flow has its roots in an infamous name in investing: Bernie Madoff. Madoff pioneered this system as a way for large market makers to profit from trading activity. At one point, Madoff’s company was paying to take about 10% of the volume on the New York Stock Exchange. That’s huge, and the influence of a single company.

Today, Major firms such as Citadel Securities and Virtu Americas are big players in the PFOF business. When brokerages stopped charging high commissions to execute trades, paying for order flow became a lucrative option to offset lost revenue.

Payment for order flow is made at many “free” and discount brokerages. Because of the controversy surrounding the practice, some runners like it public, do not participate in this. Others, like Robin Hoodthey rely on this practice as an important part of their business model.

How does order flow payment work?

Let’s dive deeper into how order flow payment works so you can understand where your money goes, how it affects you, and why it’s lucrative for investment firms.

As an example, imagine you want to sell 100 shares of Starbucks and the current market price is $100 per share. Pick up the phone, tap a few buttons, and enter a market order sell your shares.

Instead of going directly to NASDAQ to execute the trade, it is intercepted by Citadel, a major payment for order flow company. At the same time you enter your trade, the market price moves to $99.99 per share and someone else enters a limit order to buy 100 shares at $100.01 per share.

Citadel notices this discrepancy of seconds in the market. Submit your trade to fill the limit order at $100.01 per share and fill your order at the market price of $99.99. That’s a spread of two cents per share with a total value of $2 for this trade. Citadel keeps the $2 and sends some to your brokerage as payment for order flow.

Depending on the time of your mediation, you may also see a small price improvement on your order so that you get a small portion of the profits. However, the CFA Institute equates it pay a dollar to get a penny back. In general, order flow payment is a completely invisible process that can happen on almost all of your stock orders without your knowledge.

Further reading: How to protect your investments

How high frequency companies benefit from PFOF

The $2 profit from the previous section doesn’t sound like much, but imagine that the same process happens several million or billion times a day. Suddenly that stack of $2 here and $0.20 there turns into millions or billions of dollars that are split between paying order flow firms and participating brokerages that submit trades.

If you see Superman 3 or Office spaceyou know fractions of a penny can they add up to a high income over time. With PFOF, high-frequency trading firms and brokerages play in a system that distributes fractions of a penny for business profits. But when someone wins by taking advantage of high-speed trading and payment for order flow, someone else gets stuck footing the bill.

Why is order flow payment controversial?

The great controversy surrounding this practice it comes from retail consumers like you and me. In the Starbucks stock example above, the two individual traders who buy and sell 100 shares are the losers who end up giving away $2 that one of them should have been able to keep.

Instead, that $2 is split between the brokerage and the order flow company’s payment. And most consumers have no idea about it. So while investment apps like Robinhood and various full-service brokers may seem “free” on the surface, you may be paying in a way that doesn’t involve traditional commission.

The SEC requires brokers to disclose that they use payment for order flow when you open an account. Brokers must also submit reports on their net market maker payouts and order flow payout rate. And in some cases, brokers get a slap on the wrist for not disclosing that source of income clearly enough, like when the SEC fined Robinhood $65 million. But for the most part, everyday investors don’t know or realize how much money they’re losing with this business practice.

Because of this potential to exploit the small, countries like Canada have completely banned payment for order flow others are reviewing the practice. Although market makers have some rules and regulations that require them to offer traders a reasonable deal based on actual market rates, there is plenty of room to make a little profit by taking advantage of unknown individual investors.

How to avoid order flow payment

If you sign up with a brokerage firm that offers commission-free trading, there is a good chance that your orders are subject to order flow payment. The only way to avoid this practice is to choose a brokerage that does not participate or that offers you the option to opt out.

Public is one of the most popular investment apps that relies on tips to make money instead of paying for order flow. This is one of the reasons why people often choose Public over Robinhood or other similar trading apps.

Of course, it might be worth paying a small amount, even with this practice, to get the best brokerage experience for your needs. If a brokerage offers incredible service and requires this practice, it might still be a better choice than a brokerage that doesn’t use PFOF but offers lower-quality tools and resources.

If you are not committed to order flow payment, read the fine print on your brokerage website and any other broker you are considering. The practice is widespread, and you may need to do some work find a broker which sends each order directly to the market.

Is order flow payment a good practice?

This practice is a good idea for brokerage and trading firms that benefit from the practice. And some investors argue that smaller brokers can better serve clients by sending excess orders to market makers to keep things running smoothly. And, theoretically, brokers could pass on some of their PFOF profits to clients with lower fees and benefits.

However, for most individual investors, this is not a good thing. Paying for order flow introduces conflicts of interest that can ultimately be financially costly. And what’s worse is that these fees are hard to detect, even though the SEC requires brokers to disclose their policies on paying for order flow practices.

But because it’s so common and hard to avoid, you may be stuck while regulators and companies work out the details.