If you wanted to trade stocks before 2013, you would have had to pay commissions to a brokerage firm. Fast forward to today, and nearly every major brokerage firm on Wall Street offers commission-free trading.
What happened? 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. And while you might not be paying your broker-dealer to execute your deal, it turns out the brokerage firm is getting paid. This process has caused a bit of controversy in recent years, which is why some brokers like Public.com have opted out of the PFOF business model.
Table of Contents:
- What is payment for order flow?
- Key takeaways
- Understanding the PFOF meaning
- How payment for order flow works
- Criticisms of payment for order flow
- Why Public doesn’t use PFOF
- Should you choose an investment app that sells your orders?
- How PFOF impacts investors
- Frequently asked questions about PFOF
What is payment for order flow?
Payment for order flow (PFOF)is compensation that broker-dealers receive in exchange for placing trades with market makers and electronic communication networks, which aim to execute trades for a slight profit.
When a brokerage receives a stock market order, they manage the deal through a clearing firm, which routes orders. The clearing firm is responsible for making sure everything goes smoothly between the brokerage, market maker, and exchange.
The market makers executive the trade, and gives the brokerage a tiny portion of the trade value as a way to thank the brokerage for sending business their way.
Key takeaways
- Payment for order flow is when brokerage firms receive compensation in exchange for routing orders with market makers.
- These market makers make money on the difference between the bid price and ask price, which means investors may not be getting the best deal possible.
- Many zero-trading commission trading platforms use PFOF as a way to make money but may not have the investor’s best interest in mind.
- Public has moved away from accepting PFOF, instead choosing to implement an optional tipping feature. We believe this transparency between broker and investor will bring us one step closer to our mission to open the stock market to everyone.
Understanding the PFOF meaning
One of the stock market myths is that commission free trades are actually free. PFOF is a common practice among options trading and is becoming more common with stock exchange trades. It’s a concept that retail investors often aren’t aware of but many commission-free stock brokers use PFOF. Public, however, has chosen not to accept PFOF, giving its community the option to tip instead.
The process of PFOF was founded by Bernie Madoff of Ponzi scheme infamy, but his profit-incentivized method had nothing to do with his investment scandal.
According to Bloomberg columnist Matt Levine, there are generally two types of PFOF – the Good Model and the Bad Model.
In the Good Model, market makers can get a good deal on a stock and it ends up being a good deal for all involved parties. But with the Bad Model, the market makers don’t get investors the best deal but get a somewhat okay deal. It’s because of this later model that investors are taking a harder look at PFOF rather than taking it at face value and questioning whether it presents a price improvement or is a conflict of interest.
How payment for order flow works?
Online brokers with zero-commission trading tend to attract a wide array of investors. It takes a level of responsibility off of the retail customer, allowing them to learn as they go and make decisions based on the stock market’s performance, not broker fees.
However, PFOF is part of the business model of most commission-free brokers although Public has chosen not to accept PFOF.
PFOF is used to transfer some of the trading profits from the market makers back to the brokers. The ultimate purpose of PFOF is for liquidity, not necessarily to profit off client orders.
In fact, the U.S. Securities and Exchange Commission (SEC) requires broker-dealers to disclose their PFOF practice in an attempt to ensure investor confidence.
Payment for order flow example
To fully understand PFOF, you need to understand how the bid-ask spread works. This is a bracket, which represents the highest prices buyers are willing to pay, the bid, and the lowest prices sellers are willing to sell, known as the ask price.
For example, let’s say Company A’s stock has a bid price of $98.00 and an ask of $100.00. The spread, or difference between the two, is $2.
An investor decides to buy stock of Company A at $99.00. The broker receives the order and routes it to a market maker, who offers to sell it at $99.00 but first buys it for $98.90 and keeps the $0.10 difference. It might not seem like a lot, but market makers execute many trades a day, so those cents add up.
So while the investor gets the stock of Company A for the price they wanted, it’s not necessarily the best price execution quality. That’s one reason why Public doesn’t use PFOF- to reduce this potential conflict of interest and attempt to get investors better prices.
Criticisms of payment for order flow
Investors ultimately realized there was a fee hidden in their sell order, and it came in the form of a lower market value for the executed share. Brokers would execute trades based on what gave them the highest profit, not what was the best execution value for their clients.
While PFOF is thought by many to have a conflict of interest, it has remained the status quo. It wasn’t until the GameStop (GME) meme stock saga in 2021 that investors became more outspoken about PFOF and broker-dealer transparency. In fact, SEC Chair Gary Gensler said after the Gamestop saga that “payment for order flow can raise real issues around conflicts of interest.”
In 2020, four large brokerage institutions received a total of $2.5 billion in revenue from PFOF alone, making it one of the largest money generators for brokerage firms. That number was up from $892 million the year prior, meaning PFOF profits nearly tripled in just one year.
Because some market makers will offer a higher monetary incentive to brokerages than others, there are times when a company may prioritize profit over the best possible price for the client. While brokerage firms are not legally upheld by the fiduciary standard, they are bound by the best interest standard, which states that transactions must be in the best interest of client. This criticism of PFOF is one reason why Public decided not to use the practice in its own business model.
Why Public doesn’t use PFOF?
Public decided to stop accepting payment for order flow to remove that conflict of interest from our business. Instead, we’ve introduced tipping, which helps us focus on building a community we believe in.
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 our clearing firm, Apex, we are able to route all trade orders directly to exchanges (e.g. Nasdaq and the NYSE) or other venues where PFOF is not part of the execution process.
Direct routing to the exchanges is more expensive, which is why we’re turning what used to be a revenue stream (ahem—PFOF) into a cost center. And forgoing PFOF allows us to promote our core values of a transparent investing environment, as the practice can go against the positive impact that many investors have in mind when they envision a better world.
The other ways that Public makes money is through securities lending, interest on cash balances, Premium subscription fees, and other fees and partnerships.
How PFOF impacts investors?
Nowadays, investors are raising the bar for brokerages, urging transparency in business practices so they know how a company is profiting off of them and whether or not they like it.
The pushback on payment for order flow is proof that we don’t have to take stock market norms at face value. As a community, investors on the Public app are able to tip on their own accord, or save the funds while they execute trades directly with the exchange. The same cannot be said for all no-fee brokers, but that could change.
Should you choose an investment app that sells your trade orders?
Due diligence involves more than researching a stock’s performance. It means digging deep into your brokerage, too. Investors should always be aware of whether or not a broker is using PFOF and selling your trade orders to a market maker.
If they are profiting from PFOF, do they have practices in place to ensure they’re keeping the investors’ best interest at heart? This is difficult to prove, which is why more and more traders are opting for a PFOF-free environment.
If there’s no PFOF, does the broker offer an alternative way to offer funds to the market makers who make all this trading possible?
That’s why Public doesn’t use PFOF and instead uses tipping to help pay for executing market orders so we can bridge the gap between our brokerage and the investors who we serve. Besides being PFOF free, we also offer social investing. Our community members can follow friends and domain experts to see what they are investing in, exchange ideas and improve financial literacy.
Frequently asked questions about PFOF
What does PFOF stand for?
PFOF stands for payment for order flow. It’s when a broker-dealer is paid by a market maker to route orders to the market maker.
Who uses PFOF?
PFOF is used by many zero-commission trading platforms on Wall Street, as it’s a financially viable option and allows them to be able to continue offering trades with no commissions.
What is a market maker?
A market maker is a dealer who buys and sells stocks and other assets like options trading at specified prices on the stock exchange. Market makers play a vital role on Wall Street, as they create liquidity in the market.
How do market makers profit from PFOF?
Market makers make money from PFOF by attempting to pocket the difference between the bid-ask spread. This means that while investors might see some price improvement on the ask price, they may not get the best possible price.
Is Public PFOF free? What does it mean for me?
Public is PFOF free. This means that your trades are routed directly to exchanges or other venues where PFOF is not involved. Instead, there is an optional tipping option to help offset the cost of executing trades.
What is a PFOF Trader?
A PFOF trader is just another word for a broker-dealer who uses PFOF to execute retail orders.
Does it mean your free trade isn’t really free?
If a broker-dealer offers free trading, that means they could be making their money through PFOF. Your investment trades aren’t necessarily getting the best execution, as the market maker is pocketing a markup.