What is Payment for Order Flow and How Does it Work?

What is Payment for Order Flow and How Does it Work?

Before 2013, anyone who wants to trade stocks will have to pay commissions to a brokerage firm. Fast forward to today, and nearly every major brokerage firm on Wall Street offers commission-free trading. Of course, commission was the major revenue source of the brokerage firm then.

But today a different business model has given birth to this commission-free trading.

The question then is “How do these brokerages stay in business if they aren’t charging clients to trade?”

Many brokerages discovered a feature called the payment for order flow. This is such that while you might not be paying your broker-dealer any commission to execute your deal, it turns out the brokerage firm is still getting paid.The model was made popular by Robinhood.

But what really is Payment for Order Flow (PFOF) and how exactly does it work? If this sounds like what you are interested in, then let’s together find out.

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What is Payment for Order Flow?

Payment for order flow (PFOF) is compensation that brokerage firms receive for directing orders for trade execution to a particular market maker or exchange. This is usually in tiny fractions of a penny per share, but of course it easily adds up as the number of shares transacted increases.

So rather than receive a commission from investors, the brokerage firm actually receives their pay from the market makers. And why does the market makers have to pay the brokerage firms? It is because in a way, the brokerage firms are the ones sending business their way.

So this way, the brokerage firms are eager to receive stock market order without charging any commission with the knowledge that they will not be the one to manage the deal directly.

Payment for order flow is common in options markets, and is increasingly found in equity (stock market) transactions.

How Does Payment for Order Flow Work?

Investors are all turning towards Commission-free trading making payment for order flow more popular

Online brokers with zero-commission trading tend to attract a wide array of investors. And this is easily understandable seeing that the commission-free trade is something that excites so many people.

But how exactly does this payment for order flow model work?

To many people the concept of payment for order flow might be a difficult one to understand. It is possible you have read a lot on it but still don’t get it. A very easy way to understand it however is simply by looking at an example. And I will use an example to explain it now.

For instance, if you placed a buy order for 500 Meta shares with a brokerage, say Robinhood. Of course you know that Robinhood offers commission-free trading, so you don’t pay them any commission. But you also know that Robinhood will receive payment for order flow. So in order to have your order fulfilled Robinhood will have to look for a market maker to route it through. It is now the market maker who carries out the actual trade. It is also the market maker who pays the payment of order flow to the the brokerage (Robinhood, in this case).

You will probably ask me, “How then does the market maker make its own money?”

Brilliant question.

Now, here is it:

Because market makers provide the market with liquidity and depth to the market in a two-sided market comprising the bids and asks, it eventually profits from the difference in the bid-ask spread.

What is Bid and Ask and How Does it Apply?

To further explain the payment for order flow, let me break down the bid-ask spread and how it works. So what is the bid and ask spread? It refers to a range of prices buyers and sellers are willing to negotiate. The highest price buyers are willing to pay is called the bid. And the lowest prices sellers are willing to sell is called the ask (or ask price).

I go back with our Meta stock example.

Let’s say Meta’s stock has a bid price of $98.00 and an ask of $100.00. The spread, or difference between the two, is $2.

If you are an investor, you could decide to buy it at $99.00. Remember that you are placing order for 500 units. Robinhood (your broker) receives the order and routes it to a market maker. Now, this is where the magic happens. That you offer to buy at $99.00 does not mean that is the same amount the market maker will buy. As a market maker with the liquidity and who both buys and sells, it can get it for say $98.8 or even $98.5. What ever the difference is, is what it keeps as its profit. And it is from that profit that it pays Robinhood the payment for order flow.

So while as an investor you get the Meta stock for the price you wanted, it’s not necessarily the best price.

When your broker sends a stock or option order to a market maker, the third-party firm pays the brokerage to execute it.

Does it mean your free trade isn’t really free?

With this knowledge comes another question – Does it mean your free trade isn’t really free?

Not really. Or should I say it depends.

It actually depends on how fast the trades are sold or otherwise. But then deciding when it is sold isn’t in your hands. The market makers are the ones in charge of this. So depending on the type of stock you bought (hot stock whose prices are rapidly rising and falling or a less volatile stock) there might be an upward or downward difference between the price you bought and the price at which the order is executed.

Now, the gain or loss as it were goes to the market makers. Because of this they tend to wait, and monitor the market before deciding on when to execute the order. However, it is generally in their best (and even yours to sell as fast as possible).

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How Does Payment for Order Flow impact investors?

Assuming you don’t know how or what brokerages does with your money before now, I just revealed the secret. What then do you think will be the implication? You want to bargain more. You want to demand more from your brokerage firm. If nothing else you want to push for more transparency in business practices so that you have an idea how much a company is profiting off you. You want to know if it is fair enough and whether you like it.

In fact, this is one of the reasons, Public doesn’t use payment for order flow. They assume it will help reduce this potential conflict of interest and also get investors better prices.

But even if you opt not to trade through a brokerage firm, there is no guarantee you can get a better deal.

Why Public doesn’t use Payment for Order Flow?

According to Public, they decided to stop accepting payment for order flow to remove that conflict of interest in dealing with investors. Instead, they introduced tipping, which helps them focus on building a community.

Trades are commission-free and tipping is entirely optional. Members of the Public.com community can opt to leave a tip to help pay for the cost of trade execution.

With the help of its clearing firm, Apex, Public is able to route all trade orders directly to exchanges (e.g. Nasdaq and the NYSE). With this, it is able to cut off the payment for order flow compensation.

So with this, you might want to know how Public eventually makes money.

Conclusion

Payment for order flow is the money a brokerage receives when they pay an outside firm to execute the investment buy or sell orders they received from an investor. This procedure gives the market maker firm the power to carry out the investor’s trades.

Many discount brokers and commission-free investment apps utilize payment for order flow to earn compensation. But it doesn’t affect your investment choices or account safety. If you’re an active trader or day trader who regularly invests in options, PFOF might impact the final costs of your trades since the third-party firms are the one who decides the exact time to execute your orders.

But overall, the effect is quite minimal, and for ordinary investors it is almost none existent. However, if you still feel uncomfortable with the entire concept you have other options. Brokerages like Public, Fidelity and Interactive Brokers don’t make use of payment for order flow. So you can as well go with any of those.

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