What Is Payment for Order Flow and How Does It Work?

Payment for Order Flow (PFOF) is a mechanism in financial markets where brokers receive compensation for directing customer orders to specific market makers for execution. This practice influences the structure of trading for individual investors. Understanding PFOF offers insight into brokerage revenue models and trade routing.

Defining Payment for Order Flow

Payment for Order Flow (PFOF) is compensation a brokerage firm receives for directing customer orders to a particular market maker for trade execution. Instead of sending an order directly to a public stock exchange, the brokerage routes it to a market maker. The market maker then pays the brokerage a small fee for the opportunity to execute that order.

Market makers provide market liquidity by continuously quoting buy (bid) and sell (ask) prices for an asset. They profit from the bid-ask spread. Their primary motivation to pay for order flow is to gain access to a consistent stream of retail orders. This influx helps them manage their inventory and capture profits.

For brokerage firms, PFOF is a significant revenue stream. This compensation allows many brokers to offer commission-free trading, a prevalent feature in retail trading. PFOF helps offset the costs of providing trading services when traditional commissions are not charged.

The Mechanics of Order Routing and Payments

The process of how a retail trade is handled through Payment for Order Flow involves several distinct steps, beginning with the investor. When a retail investor places a buy or sell order through their brokerage account, the brokerage firm receives this instruction. Instead of immediately sending the order to a traditional stock exchange, the brokerage may direct it to a specific market maker with whom they have an existing PFOF agreement.

Upon receiving the order, the market maker executes the trade. This often occurs through a process called “internalization,” where the market maker fills the order from their own inventory of securities rather than sending it to an external exchange. After execution, the market maker pays the brokerage a small fee, typically a fraction of a cent per share, for the order flow received. Payments might be as low as one cent per share, or even less, depending on the agreement.

Once the trade is executed by the market maker, a confirmation is generated and sent back through the brokerage firm to the customer. This entire process is often highly automated, utilizing sophisticated systems to route and execute orders efficiently. The revenue generated from these small payments across millions of trades can amount to substantial sums for both market makers and brokerage firms.

Regulatory Framework

The regulatory environment surrounding Payment for Order Flow aims to ensure transparency and fairness in the marketplace. In the United States, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are the primary bodies overseeing these practices. These regulators mandate how brokers must disclose their order routing practices and the compensation they receive.

SEC Rule 606 requires brokerage firms to publicly disclose detailed information about their order routing. This includes quarterly reports that itemize where customer orders are routed and the amount of PFOF received from each market venue. Brokers are also required to inform customers about their PFOF practices when a new account is opened and annually, providing a general overview of compensation.

Despite PFOF, brokerage firms are bound by the “best execution” obligation. This duty requires brokers to use reasonable diligence to find the best market for a customer’s security and ensure the most favorable terms. Factors for best execution include execution price, speed, likelihood of execution, and opportunities for price improvement. This means brokers must prioritize the most advantageous outcome for customer trades.

How PFOF Influences Retail Trading

Payment for Order Flow shapes the retail trading experience by enabling widespread zero-commission trading. The revenue brokers earn from PFOF allows them to eliminate direct trading fees, making market participation more accessible. This model is a component of many brokerage firms’ operations, especially those catering to active retail traders.

PFOF can also influence execution quality. Market makers, to attract order flow, often provide “price improvement,” executing an order at a price better than the National Best Bid and Offer (NBBO). For example, a buy order might be filled below the lowest ask price, or a sell order above the highest bid price. While this benefits the investor, the broker’s incentive to receive PFOF might outweigh the pursuit of maximal price improvement for every trade.

Regulatory disclosures related to PFOF contribute to market transparency. Under SEC Rule 606, investors can review their broker’s order routing practices and understand where their orders are executed. This transparency allows investors to gain insight into how trades are handled, fostering a more informed understanding of market mechanisms.