Payment for Order Flow, explained

New investors are flowing into the stock market in record numbers, fueled by online trading apps that offer commission free trading, borrowing on margin, and options trading. Meanwhile, brokerage firms have been raking in huge revenues. In fact, one important revenue stream almost tripled for four large brokers from 2019 to 2020. How are brokerages generating so much revenue while offering commission free trades? A process called Payment for Order Flow.

So how has PFOF changed things? Typically, brokerages make their revenue by providing various products and services to their customers, over 75% of which are retail investors. ‘Commission free’ means investors don’t pay a fee to their brokerage every time they buy or sell a stock. And yet brokerages are making more money than ever before. Somehow this doesn’t add up.

It’s important to understand what happens when an investor chooses to trade a security. When an investor commits an order, their brokerage routes that order to a public exchange for execution. The investor sends money, the brokerage sends back shares of stock. That is usually what the investor sees. Easy peasy.

However, within the Payment for Order Flow model that process has an extra step. Say an investor wants to buy 100 shares of stock in the Company XYZ. The investor confirms the order and their brokerage routes that order to a third party, instead of a public exchange. These third parties are financial institutions known as Market Makers. And that’s precisely what they do: they “make markets” by providing two sides of the trade. Put another way, they buy and sell stocks. But market makers are paying brokerages to send them orders. So why would a market maker pay to be able to execute orders?

The simple answer is, it’s financially beneficial to do so. A key to understanding how is the bid-ask spread. The bid ask spread is a bracket, representing the highest price buyers are willing to pay for a stock, the bid, and the lowest price sellers are willing to sell that stock, the ask. Depending on the fluctuations of supply and demand, it represents the price of a stock at any given time. As trades are made, data flows from public exchanges and aggregates into a listing known as the NBBO, or National Best Bid and Offer. So when investors see a stock price for a company on their brokerage app, what they’re actually seeing is the price generated from the NBBO.

To illustrate how this works, let’s suppose the bid of Company XYZ stands at $99.00 and the ask sits at $100.00, creating a spread of $1. An investor wants to purchase shares of XYZ at the mid-point of $99.50. That order goes from investor to brokerage and then reroutes to a market maker. The market maker may offer to sell at $99.50, but not before purchasing those shares at $99.40, pocketing the difference of .10 cents in the process. So while the investor recognizes some price improvement, they’re not receiving the best execution, losing value overall.

“They have to go out and get the best possible price for their customer when that customer wants to buy or sell a stock,” says Dave Lauer, CEO of Urvin Finance and a former high frequency trader. He goes on to say “that doesn’t mean a good enough price. It means the best possible price. And that’s a big distinction because it’s often easy to find a price that’s at the NBBO or just a little better.” Essentially, price improvement is like a tug of war, between who receives the better deal on a trade. But when this practice gets repeated millions of times a day, it generates enormous profits for the market maker.

However, according to the SEC, brokerages have a fiduciary duty to offer investors the best possible price. So how do brokerages make money on these transactions? Brokerages and market makers have pre-existing contracts in place, whereby market makers pay brokerages a commission for sending their trade orders to them, instead of the exchanges. Taken all together, brokerages make money from these contracts, market makers produce profit inside the bid-ask spread and the investor… loses value in their portfolio.

Investors seek quality price execution, and that starts with the right brokerage. Just as investors should research a company they’d like to invest in, they should also research the institutions they trade with, and know if it routes to market makers. Forming a clear picture of how a brokerage generates its revenue is vital. Newer brokerages like Public are doing away with PFOF altogether, and maintaining quality-price execution without routing to market makers. Learning the mechanisms of the market can help avoid a world of hurt, and offer some peace of mind. Educational resources, like those at Public.com, are a great place to start.

A final bit of advice from Dave Lauer: “a broker is there to act as your agent and to navigate the complexities of the market… they have a fiduciary duty of best execution, where the responsibility is on them to make sure that when you want to buy or sell stock, they get you the absolute best and most advantageous terms possible.” Brokerages should support their customers and look out for their best interests. Ones that don’t might only be looking out for themselves.

To sign up and see what trading is like without PFOF, visit Public.com.