Years ago, if you wanted to access the stock market, you had no choice but to pay commissions to brokers who facilitated your trades. It makes sense — Wall Street brokers aren’t going to work for free.
This begs the question: How are all these commission-free brokerage firms offering zero-commission trading? How do they make any money for themselves to stay in business?
The answer, in the vast majority of cases, is a process known as payment for order flow, or simply PFOF. Through this process, even though you aren’t paying a fee to make your trade, the broker you made your trade with is getting paid.
What Is Payment for Order Flow (PFOF)?
PFOF is a way for commission-free brokers to make money when their customers trade stocks. The money is generated by directing customer orders to third parties for trade execution. These third parties are known as market makers.
These market makers are typically large firms that work with a set number of stocks and options, keeping a large inventory of these assets on hand. Each time a brokerage routes orders to one of these market makers rather than facilitating the trade themselves, they receive a percentage of the money the market maker makes from the trade.
Through this process, retail brokers generate revenue for themselves based on the volume of stock trading and option trading that happens on their platforms.
Many of the most popular discount brokerages disclose millions of dollars in PFOF payments each year. These include everyday names like Robinhood, TD Ameritrade, Schwab, Webull, and eTrade.
While the practice is common in financial markets, specifically among commission-free brokers, there’s quite a bit of controversy surrounding it, which we’ll get into a bit later.
How Payment for Order Flow Generates Revenue
According to legal disclosures from Robinhood, E*Trade, TD Ameritrade, Schwab, and Webull, they all collect millions of dollars per month from marker makers like Citadel Securities, among others, in exchange for routing order flow to them.
You might be thinking, “Wait — these are commission-free trades. Where is the money to pay the broker coming from?”
Those funds are baked into the trade.
Every time you trade a stock or other financial assets, there will be a bid-ask spread — a difference between the bid price (the highest amount a buyer is willing to pay) and the ask price (the lowest amount a seller is willing to accept).
This spread, often a very small percentage of the value of the stock as a whole, becomes the market maker’s profits. From there, a share of those profits are provided to the brokers that routed them the client orders based on predetermined order flow arrangements.
For example, if you’re trading with one of these brokers and you notice a spread of $0.05 on a stock, a portion of that spread will be paid to the market maker with a percentage coming back to the broker.
Benefits of Payment for Order Flow
The PFOF practice offers multiple benefits to investors. While some of these benefits are clear, others have been claimed by broker-dealers and market makers and have yet to be proven out.
Some of the most significant benefits of payment for order flow include:
1. Lower Commissions
Commissions on trades with traditional brokers — especially if you’re not trading large blocks of shares — are expensive. However, thanks to the PFOF model, many brokers now offer commission-free trading, saving retail investors expenses that would have otherwise cut into their profits.
2. Price Improvement
Order flow is the mechanism that facilitates price movement in the stock market. If no orders were executed, the prices of assets would essentially stay the same. There’s an argument that massive firms that hold large inventories of stocks and options make it possible for the market to function given the volume of stock trades that take place.
On the other hand, this is one of the theoretical benefits that have been claimed by market makers. It hasn’t quite been proven that PFOF results in better or more efficient pricing for investors.
3. Increased Market Liquidity
When you place a market order to buy or sell a stock, you expect that transaction to happen right away at whatever the current average price is. Orders that need to happen immediately go through market makers, and they charge a fee for “crossing the spread,” or being willing to pay the “ask” price when other bidders aren’t in order to fill your market order.
These orders generally require involvement of market makers to make them happen immediately. So, in some ways, PFOF does increase market liquidity by making market orders possible.
Criticism of Payment for Order Flow
While PFOF offers some benefits to investors, every rose has its thorns, and this practice is covered in them! Payment for order flow has created quite a bit of controversy, which has even led to an Securities and Exchange Commission (SEC) investigation that nearly resulted in banning the process altogether.
Some argue that the benefits outweigh the drawbacks, which led to the SEC allowing the practice to continue. Others believe a monopoly among the world’s largest brokers resulted in pressure on the SEC to act in the brokers’ and market makers’ favor, rather than in the best interest of retail investors.
Either way, there are some serious drawbacks to consider before getting involved with a broker that takes part in payment for order flow.
1. Conflict of Interest
Many argue that the PFOF process creates a conflict of interest that’s pretty easy to see.
Many market makers are also hedge funds — large investors that often make their money by betting against the masses. Therefore, by routing retail customer orders through these hedge funds, the practice gives the hedge fund an even larger advantage in the market than it already had.
Think about it this way: It’s like going to your buddy’s house for poker night, but your buddy is always the dealer, and before he deals you your cards, he looks at them. It would be impossible to beat the house.
Moreover, some argue that PFOF orders are often facilitated through dark pools, hiding buy volume on stocks from the market as a whole and limiting price appreciation on stocks hedge funds are short on.
That’s why so many retail traders worked together to purchase stocks that were heavily shorted by hedge funds that also acted as market makers. In fact, it’s this conflict of interest that led retail investors to band together during the Big Short Squeeze, an event that resulted in GameStop and other meme stocks clocking in gains far and above 1000% in an effort to punish hedge funds.
Nonetheless, when institutional investors are able to get first crack at every trade that’s executed by paying the brokerage platforms for their order flow, there is indeed a clear conflict of interest.
2. Inferior Pricing
Another issue with PFOF is that it leads to insinuations that commission-free trades are actually completely free. However, that’s not at all the case, especially when the process of PFOF requires traders to pay a spread to make it a profitable process for the brokerage.
In some cases the practice doesn’t even lead to better prices. Sure, when trading small blocks of shares, paying a few extra pennies in the spread is going to be less than paying a $4.95 commission. But when trading larger blocks of shares, spreads charged on each share can easily add up to more than the average commission from a traditional broker that charges a fee rather than being paid to route orders.
For example, if you buy 10,000 shares of a stock with a half-penny spread, the trade will cost you $50.
3. Not in Investors’ Best Interests
There has long been an argument that PFOF isn’t in the best interest of investors. In fact, payment for order flow has been criticized since it started. The process was invented in the 1990s by Bernie Madoff — the same guy who would later become infamous as the perpetrator of a massive Ponzi scheme.
Although those who believe in the practice point to best-execution rules that require brokers to use the market maker with the best price, or lowest spread, that doesn’t mean that the process is in the best interest of investors.
In fact, the criticism led to an investigation by the U.S. Securities and Exchange Commission in 2020 after retail traders waged a mountain of complaints.
Changes Made in 2020 to Protect Investors
As a result of the potential conflict of interest that exists in the process, regulatory authorities put rules in place in 2005 to ensure that investors were aware of PFOF activities. These rules are known as Rule 605 and Rule 606, which require broker-dealers to display execution quality and payment for order flow statistics on their websites.
Over the years, regulators and participants have changed the formatting of reporting, with the most recent change taking place to Rule 606 in 2020. The change required brokers to provide net payments received each month from market makers for trades executed in S&P 500 and non-S&P 500 equity trades and options trades. Brokers also must disclose the rate of PFOF received per 100 shares by order type.
Brokers Who Don’t Use Payment for Order Flow
The vast majority of discount brokers use payment for order flow. In fact, there are currently only two major brokers that offer commission-free trading and don’t take part in PFOF activities. Those brokers are Vanguard and Fidelity.
Whether a broker uses PFOF or not, they need to make money. After all, without revenue coming through the doors, these guys are out of business. So how do these brokerages survive without making revenue from trading commissions or PFOF?
As with other discount brokers, Vanguard and Fidelity charge commissions and contract fees on options and futures trades. They also offer margin accounts, earning revenue from interest on money users borrow to trade and invest.
At the same time, these companies also offer financial planning, advice, and other services that drive substantial revenue, keeping them afloat without receiving revenue kicked back from market makers.
Payment for order flow is an interesting topic because it has reduced the cost of trading for retail investors in many cases, but it’s also a double-edged sword that provides hedge funds with data that gives them an upper hand in the market.
Keep in mind that the SEC requires the disclosure of the use of this practice, although finding the disclosure with some brokers may be difficult.
Nonetheless, if you want to avoid brokers that take part in these activities, the best brokers to consider would be Fidelity or Vanguard.