Payment for order flow

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Payment for order flow
/ˈpeɪmənt fər ˈɔːdə fləʊ/ (n.)
An arrangement between a securities broker and its favourite market-maker where the market-maker pays the broker to steer its client order-flow to the market maker, allowing the broker to charge lower, or nil, commissions to their retail clients.

It was a thing in Europe for years, and the Americans — usually such fastidious over-regulators of this kind of thing — have been strikingly blasé about it, and it remains a thing. The American love of playing the markets so depends on it, in fact, that before 2021, the JC often heard it confidently expressed that there was zero chance of the SEC limiting PFOF because the Americans retail market so loves its commission-free brokerage accounts. My American pundit friends have been less garrulous since GameStop, but they are still quietly, superciliously confident it won’t be any time soon.

In any case it was all brought into sharp, public relief, in the great market un-crash of January 2021, when the massed armies of the investing public — for so long a huge, docile cow, tethered to the stall and irretrievably wired into the great financial services milking machine — woke up and decided to have things their way, for once.

Said institutional milking machine reacted a bit petulantly, complaining about these nasty, predatorial, well, regular joes, in their tracksuits making life hard for the brokers and their time-honoured, noble, sacred pursuit of extorting the American public. In a turn of events characteristic of the information revolution, there was a great awakening within the Reddit day-trader community, who discovered they were the product, not the customer, and the means of that transmission was payment for order flow.

What is PFOF?

The theory is — ought to be — that when your order is filled you pay your broker a commission. Your broker has all kinds of regulatory obligations — the key ones are generally lumped together and called “best execution” — to make sure you get the best price available. This keeps the broker honest.

Okay. Now a broker fills your order by going to the market. In practice this means The broker will interrogate market makers, exchanges and other sources of market liquidity (multilateral trading facilities dark pools and so on), to identify that best price, retrieve it and bring it back for you.

Note the inherent asymmetry here: on one side of the broker millions of tiny investors, each paying teeny commissions. On the other side, a small number of market intermediaries, each hoping to handle a vast volume of transactions, charging even teenier commissions, but in such colossal quantities that in aggregate it makes a lot of money.

The more “order flow” an market-maker gets, that is to say, the more money it makes.

Like brokers, market-makers are agents: they do not take a true principal position, but merely route customer orders to the market. Their revenue is an annuity: it depends on volume. Market-makers will (if allowed happily pay “retrocessions” for volume to individual brokers. They pay, in other words, for order flow.

They are allowed to do that in the US; they are not in the UK. The FCA banned payment for order outright in 2012 on the theory that it undermines transparency and efficiency, is inimical to the idea of best execution, and also it creates a perceived conflict of interest between broker and clients.

In the US the dynamic is very different. Payment for order flow allows the retail platforms (Ameritrade, Schwab, eToro, RobinHood etc) to offer commission free trading.

Like in Vegas, if the drinks are free, you are paying some other way. Most retail folks are happy enough with that trade: brokers have to disclose their PFOF arrangements. Sunlight is the best disinfectant, right? But for the most part the conflict of interest is more optical than fundamental: neither the broker nor the market-maker has a dog in the fight: as long as the trade gets done, everyone gets their little nibble on the client’s parcel and all is well in the world.

The GameStop market un-crash of 2021 has highlighted, starkly, that conflict of interest becomes a bit more visceral when it turns out the market maker’s brother has a dog in the fight. Some market-makers are part of bigger financial services organisations, and may also have a broker-dealer, an asset manager and even — dramatic look gopher —a hedge fund in the same market.

Now if the hedge fund is short a stock that retail markets are buying like crazy through the trading platform then — hold on tiger. If all the long interest is coming through the retail platform, and all the short interest is institutional, then if the long activity on the platforms can be dampened somehow — you know, by the platform suddenly shutting down the ability for punters to put risk on, and only allowing them to take risk off — that makes the job of shorting the kahunas out of the market a lot easier.

See also

• GameStop and the great market un-crash of 2021
• Inducements and the rule against them.
• Conflict of interest
• The FCA’s FCA Marketwatch 51 of 1 September 2016 should give you what you need. If that isn’t enough, have a look at the FCA’s original Thematic Review TR 14/13 of best execution and PFOF.

References

Oh lord, where to start.

Payment for order flow was a big deal in Europe for years, and the Americans — usually such fastidious over-regulators — have been strikingly blasé about it. Much of the American love of playing the markets depends on it, in fact.

All this was brought into sharp, public relief, in the great market un-crash of January 2021, when the massed armies of the investing public — for so long a huge, docile cow, tethered to the stall and irretrievably wired into the great financial services milking machine — woke up and decided to have things their way for once.

Said milking machine reacted rather petulantly. In the mean time a great awakening was happening. In a turn of events that is rather characterising the digital revolution, the denizens of Reddit discovered they were the product, not the customer, and the means of that transmission was payment for order flow.

What is PFOF?

The theory is — ought to be — when your order is filled you pay your broker a commission. Your broker has all kinds of regulatory obligations — the key ones are generally lumped together and called “best execution” — to make sure you get the best price available. This keeps the broker honest.

Okay. Now a broker fills your order by going to the market. In practice this means The broker will interrogate market makers, exchanges and other sources of market liquidity (multilateral trading facilities dark pools and so on), to identify that best price, retrieve it and bring it back for you.

Note the inherent asymmetry here: on one side of the broker millions of tiny investors, each paying teeny commissions. On the other side, a small number of market intermediaries, each hoping to handle a vast volume of transactions, charging even teenier commissions, but in such colossal quantities that in aggregate it makes a lot of money.

The more “order flow” an market-maker gets, that is to say, the more money it makes.

Like brokers, market-makers are agents: they do not take a true principal position, but merely route customer orders to the market. Their revenue is an annuity: it depends on volume. Market-makers will (if allowed happily pay “retrocessions” for volume to individual brokers. They pay, in other words, for order flow.

They are allowed to do that in the US; they are not in the UK. The FCA banned payment for order outright in 2012 on the theory that it undermines transparency and efficiency, is inimical to the idea of best execution, and also it creates a perceived conflict of interest between broker and clients.

In the US the dynamic is very different. Payment for order flow allows the retail platforms (Ameritrade, Schwab, eToro, RobinHood etc) to offer commission free trading.

Like in Vegas, if the drinks are free, you are paying some other way. Most retail folks are happy enough with that trade: brokers have to disclose their PFOF arrangements. Sunlight is the best disinfectant, right? But for the most part the conflict of interest is more optical than fundamental: neither the broker nor the market-maker has a dog in the fight: as long as the trade gets done, everyone gets their little nibble on the client’s parcel and all is well in the world.

The GameStop market un-crash of 2021 has highlighted, starkly, that conflict of interest becomes a bit more visceral when it turns out the market maker’s brother has a dog in the fight. Some market-makers are part of bigger financial services organisations, and may also have a broker-dealer, an asset manager and even — dramatic look gopher —a hedge fund in the same market.

Now if the hedge fund is short a stock that retail markets are buying like crazy through the trading platform then — hold on tiger. If all the long interest is coming through the retail platform, and all the short interest is institutional, then if the long activity on the platforms can be dampened somehow — you know, by the platform suddenly shutting down the ability for punters to put risk on, and only allowing them to take risk off — that makes the job of shorting the kahunas out of the market a lot easier.

See also

• GameStop and the great market un-crash of 2021
• Inducements and the rule against them.
• Conflict of interest
• The FCA’s FCA Marketwatch 51 of 1 September 2016 should give you what you need. If that isn’t enough, have a look at the FCA’s original Thematic Review TR 14/13 of best execution and PFOF.