The Growth of PFOF and How it Really Works

Payment for order flow (PFOF) is a unique kind of practice where big players or wholesale market makers pay brokers (which may typically be typically retail brokers) for their clients’ order flow. The acquisition of order flow in large quantities like that enables market makers to trade profitably against client orders.

On the other hand, their clients may benefit from reduced or zero trading costs because the commissions of retail brokers are subsidized by the payments they receive from wholesale market makers by virtue of bulk or large scale of order flow directed towards the
market makers.

Here's How It Works:

A broker routes a commission-free retail trade to a wholesaler or market maker instead of traditional stock exchanges because market makers often offer better prices and brisk execution by dint of their volume of transactions and market share. This approach does not only enhance the probability of matching the order but increased profit volumes through increased volume of stock.

It's clear that payment for order flow has turbocharged market makers’ growth over the years numerous new entrants have been racing to imitate the strategy in pursuit of mega-profits. For example in February, more than half of Robinhood's (A renowned trading company) revenue came via payment for order flow.

They made more than $600 million from it in 2019 and almost $200 million in third quarter of 2020 alone.

The overall statistics of growth in Payment For Order Flow show astonishing results. It is evident that loss of a probable source of revenue from retail PFOF arrangements combined with the low profitability of servicing retail clients especially the constant attractiveness of internet execution has resulted in PFOF becoming an inexpensive, utility-like service.

WIN-WIN Solution For Everyone:

Payment for order flow is extremely important and beneficial for small broker-dealers with limited resources i.e. inability to invest required
capital for building a system on such large-scale as market makers already
possess and acquiring technology to competently execute loads of transactions  every day for their clients.

Routing their trades to large-scale wholesalers enables them to offer faster service and generate additional revenues to balance out the effects of charging lower commissions.

The economies of scale built by market makers are made available to smaller firms and their clients, along with swift execution of orders for which they owe a big thanks to comprehensively automated electronic tools which help them match the orders as per requirement.

Legislative Amendment:

Most of the retail clients are unaware of the fact that the broker they have hired, gets paid by the large scale wholesaler or market makers for routing the order or trades toward specific entities. Most of them do not pay much attention to this aspect which is very important as it defines and shapes the return on their investments.

Actually sum of amounts paid to brokers for such trades in normally small. Typically such payments for order flow may consist of few tenths of a penny per share which is small that it is often neglect able in comparison to the expected gains of the clients. These amounts are not significant for long-term investors who practice buy-and-hold strategies. However, for active traders with high frequency of transactions, the amounts can accumulate and raise some eyebrows affecting the opportunity cost of the transaction negatively.

To avoid such conflicts or confusions, the Securities and Exchange Commission demands to brokers to disclose if they paying for order flows. The market observed an increase in the proportion of retail-sized trades executing at best quoted prices from 65% to more than 90% between 2010
and 2014 and the numbers have been increasing since then.

In 2018, the Securities and Exchange Commission amended its Rule 606 with changes aimed at payment for order flow. It requires brokers to disclose payment for order details with their clients by providing them with quarterly reports. In addition to these disclosures, brokers are required to provide the clients with the identity of the entity that is paying them for order flow. A renowned trading company has been fined $65 million by SEC for hiding payment information from the clients in the past.

The Criticism:

Criticism on PFOF is more ethical in nature. Critics of PFOF argue that PFOF arrangements generate a conflict of interest in brokers’ best execution obligations to their clients. Specifically, brokers may be offered lucrative incentives to route the trade to a specific entity or market which allows the big players to mold make the market favorable to them which virtually is a form of creating monopoly and controlling large value of stocks.

Trading venue offering the best prices and fastest execution are often left behind in such scenario. However, a market with less complex structure can resolve this conflict and yield better execution outcomes if a holistic
approach is adopted.

The market makers who pay brokers to route transactions to themselves or a specific entity put the investor at disadvantage as they may buy the shares at the low end of bid-ask spreads and then sell them to an investor who has placed an order for shares at the higher end of the bid-ask spread. However, large scale wholesalers see it more as an arbitrage
opportunity rather than ethical dilemma.

Is it Legal?

For the time being, payment for order flow transactions is completely legal until and unless their details are disclosed to customers and regularly updated on quarterly basis.

Many controversies about the consequences of order flow arrangements have risen from time to time in relation to unfair profit distribution and brokers’ ethical obligations towards client. However, brokers argue that such modalities lower trading costs and the clients benefit from savings over each transaction.

Some Important Tips:

Being a retail investor can be tough sometimes. If you are a retail customer and want to get hold of your orders ensuring profits and avoid unnecessary routing of orders, you must consider hiring a financial advisor which is not that hard to find these days.

There are many automated tools available online which can match you with desired financial advisor in no time. You also need to make sure that your investments fit your risk profile. You can get your asset allocation calculated that certainly help you align your assets with your risk tolerance.