Payment for Order Flow is a super interesting thing that the market does that funnels your trades to other companies to execute on. It’s important to understand because it can do funny things to your orders. There are a lot of moving parts in the market, and helping to understand them will make you a better trader. The same way that learning about what's under the hood of your car can keep you from getting hoodwinked at a dealership. What do you say when the mechanic comes over and tells you that they need to replace your spark plug injector?
First and foremost, this isn't a democracy. Not all trades are created equal, especially in the pursuit of making bank. A hot topic in the finance industry is centered around Payment for Order Flow (PFOF). If you're in the computer science space, it's similar to Net Neutrality. PFOF is the compensation and benefit that a brokerage receives for directing orders to other companies. Brokerages are essentially reimbursed for “doing business” with companies that then execute trade. This can be a little concerning because when you buy and sell, it's hard to be certain that your trades are being routed with your best interests at heart. The SEC has stepped in to try to add some transparency to the practice. Usually the terms of the payment are based on the number of shares, or the number of orders, that are directed to these trade execution firms.
All of this got started in the 1980’s when Bernie Madoff had his firm begin to purchase OF. He would pay Fidelity or Charles Schwab a penny or two per share just for the right to make their trades. Back in those days, the NYSE required a minimum markup of one-eighth of a dollar ($0.125), but now it’s down to fractions of a penny. This all adds up pretty substantially though. Consider that in 1997, Larry Harris reported that 24% of E-Trade’s transaction revenue came from PFOF, but four years later in 2001, this only made up 15% of transaction revenue. Firms are still able to make hundreds of millions of dollars from PFOF though.
So, here's the quick and dirty about the sides of this heated battle.
Here are the arguments for why this is a good thing:
- PFOF allows smaller firms to route the trade volumes that they can’t fulfill onto other firms and still make money, this allows smaller firms to stay in the game and can help to increase competition in the market place.
- Market makers or exchanges benefit from the additional volume, and so it makes sense for these organizations to pay for the value that someone else has created for them. The liquidity that these exchanges get is worth something.
- Many have said the PFOF can lower the price of commission fees for all of the brokerage’s clients. This is nice if you’re a retail investor.
Here are the arguments for why this is a bad thing:
- Exchanges tend to want to purchase the OF because they believe that it’s uninformed buying, from people who need to raise cash for other reasons, or just plain don’t know what they’re doing. In theory, this lets brokerages capture the bid/ask spread more easily.
- This practice may also reduce liquidity on other exchanges which, can increase the bid/ask spread for that exchange.
- Brokerages may not always be incentivised to send investor orders to the exchange that is offering them the best price, but instead may send the orders to exchanges that offer the highest PFOF.
Top executives at TD Ameritrade Holding Corporation even told a senate hearing panel in June of 2014 that they regularly send customer orders to trading venues that provide their company with the highest payments (here's their 606 report). Often times, these routing decisions typically send client orders to exchanges that have long waiting times relative to other exchanges, mostly because there are other company that are also trying to get those sweet sweet PFOF. This sounds like a great time for the SEC to get involved right? Right.
Now, if you sell your OF to a firm that will execute it, you have to disclose that publicly. In one of my previous articles I provided a link to see Robinhood’s PFOF, but you can see this for any brokerage. You can also ask your own brokerage about how they route your specific orders. They are required to do so for the last 30 days. All of this transparency is supposed to hold brokers responsible, with TD Ameritrade coming out and saying that they regularly send orders where the money is, it’s hard to put your faith in these regulations.
So what does this mean for you? Well, let’s say you’re trading with a brokerage that gets some money by selling their OF. Well, you may see some interesting things happen to your limit orders for instance. Limit orders are a great example of what generally happens. Firms that purchase OF do so because they can make money with it. They make money be capturing that bid/ask spread. For example, if you place a limit order to purchase a stock when it falls below $20, your brokerage will send that on to an execution firm. The execution firm will then wait to fill your order when the price falls below $20, but not at $20. The execution firm is waiting for the price to fall to $19, so that they can keep that extra dollar, and pass on the share for $20 to you.
Above is a very drawn out example, but you may notice that your orders don’t always fill when the price just touches your limit order, this is because the firm won’t execute on it until there is a difference between your limit price and the price of the market, so that they can capture what’s in the middle. This bit in the middle is called the spread, and that's what the guys who execute on your trades get to take home.
Everything in between the two lines above is called the spread, and while this is the holy grail of trading, we'll get more into that later.
There is still quite a lot of debate about PFOF, and whether it’s a good thing or not. It looks like it’s here to stay though, and hopefully this may shed some light on how the markets work. If nothing else, understanding how the car works will make you a better driver. And that can explain a lot of the price shifts that we see that may not always be obvious based on news or world events.