What Is Payment for Order Flow and How Does It Work?
Unpack Payment for Order Flow (PFOF). Understand this financial industry practice, its operational dynamics, and the oversight mechanisms in place.
Payment for order flow (PFOF) is a common practice in financial markets where brokerage firms receive compensation for directing customer buy and sell orders to specific market makers for execution. This arrangement influences how individual investor trades are handled and is a significant part of modern securities trading, especially for commission-free services.
Defining Payment for Order Flow
Payment for order flow (PFOF) is a financial arrangement where a brokerage firm receives compensation from a market maker for routing customer orders. This compensation is a fee paid by the market maker to the broker. The arrangement centers on the broker’s ability to direct a large volume of retail trade orders to market makers.
Three parties are involved: the retail investor, the broker-dealer, and the market maker. A retail investor initiates a trade through their brokerage account. The broker-dealer facilitates the trade request. The market maker is a firm that buys and sells specific securities, providing market liquidity.
Payments are typically a small fraction of a cent per share, accumulating significantly due to the vast trade volume. Brokers are compensated for aggregated order flow, not individual trades. This practice gives market makers access to a consistent stream of retail orders, which are often smaller and less complex than institutional orders.
Market makers value this order flow because retail orders are generally “uninformed.” This means they are not based on proprietary knowledge or analysis that could move market prices. This characteristic makes them less risky for market makers. PFOF is a payment for executing these orders and capturing the bid-ask spread.
The Mechanics of Order Flow Payments
When an investor places an order, their broker-dealer receives the instruction. Instead of executing the order themselves or sending it directly to a public exchange, many broker-dealers route these orders to specific market makers with PFOF arrangements.
The broker-dealer directs the order to the market maker offering the most attractive terms, often including PFOF. Market makers pay for this order flow to profit from the bid-ask spread. The bid-ask spread is the difference between the highest price a buyer will pay (bid) and the lowest price a seller will accept (ask). By executing both buy and sell orders from this directed flow, market makers capture this spread.
For example, if a stock has a bid price of $10.00 and an ask price of $10.01, a market maker executing a buy order at $10.01 and a sell order at $10.00 earns one cent per share. A consistent flow of retail orders, often small and balanced, helps market makers maintain steady spread-based profits. This access to diverse order flow helps market makers manage inventory risk and provide competitive pricing.
Broker-dealers accept these payments to support zero-commission trading models for retail investors. PFOF revenue offsets the lack of direct trading commissions, allowing brokers to offer “free” trades. This revenue stream contributes to the broker’s operational costs and profitability, indirectly subsidizing client services.
Regulatory Oversight of Payment for Order Flow
Regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) oversee payment for order flow practices in the United States. They establish rules to ensure transparency and fairness in customer order routing and execution.
Broker-dealers engaged in PFOF must disclose their arrangements. SEC Rule 606 mandates public disclosure of order routing practices. This rule requires firms to publish quarterly reports detailing venues where they route customer orders and material aspects of their relationships, including any PFOF received.
Another regulatory principle is “best execution.” This requires broker-dealers to use diligence to find the best market for a security and execute customer orders at the most favorable price. While PFOF is permitted, it cannot compromise a broker-dealer’s duty to seek best execution. Firms must show their routing decisions prioritize execution quality over PFOF.
FINRA Rule 5310 outlines factors broker-dealers consider when routing orders. These include price improvement opportunity, execution speed, likelihood of execution, and transaction cost. Broker-dealers must periodically review execution quality from different venues to meet best execution obligations.