There is no such thing as a free stock trade. Even in a commission-free model, a brokerage is paying for that trade somewhere in their operating expenses. But for many brokerages, that fee is covered in something called a payment for order flow (PFOF).
PFOF became a part of mainstream financial literacy in early 2021 when the market criticized some brokerages for their financial practices. What does payment for order flow mean, and why is it important to investors?
- Payment for order flow is a way for market makers to incentivize brokers to execute trades through them.
- PFOF has always been problematic, but the issue has been extra hot in 2021. Financial institutions are seeing higher profits than ever from PFOF, with one broker earning as much as $182 million in PFOF profit in a single quarter.
- Brokerages that use PFOF may not always have the investor’s best interest in mind, instead choosing to execute where they’ll make the most money.
- Commission-free brokers have historically hidden behind PFOF as a way to keep the cost out of the front end of the trade, instead making traders pay for higher market values.
- Public has moved away from PFOF, instead choosing to implement an optional tipping feature. We believe this transparency between broker and investor is just what the stock market needs.
What is payment for order flow?
Think of PFOF as a deal between a brokerage and a market maker.
To execute a stock market order, a brokerage deals with a clearing firm. During the trading process, a clearing firm holds the task of streamlining the trade and making sure everything goes smoothly between the brokerage, market maker, and exchange.
Market makers (or professionals seeking to profit on the bid-ask price of a security) will execute the trade. Meanwhile, the market maker gives the brokerage a fractional profit as a way to thank the brokerage for sending business their way.
The process of PFOF was actually founded by Bernie Madoff of Ponzi scheme infamy, but his profit-incentivized method had nothing to do with his investment scandal.
In 2000, Madoff compared PFOF to a retail sale scenario: “If your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings.” He basically likens the stock execution to a retail exchange, saying that incentivization is a natural process.
Despite his argument, modern investors are taking a harder look at PFOF rather than taking it at face value.
How no-fee brokers make money on PFOF
Commission-free brokers tend to attract a much wider array of investors. It takes a level of responsibility off of the investor, allowing them to learn as they go and make decisions based on the stock market’s performance, not broker fees.
However, PFOF accompanies most commission-free brokers. No-fee operations in the late 1990s used PFOF to manage profit while offering fractional shares. Investors ultimately realized there was a fee hidden in their trade, and it came in the form of a higher market value for the executed share. Brokers would execute trades based on what gave them the highest profit, not what was the best value for their clients.
This notion has continued until today, but PFOF has remained the status quo for quite some time. It wasn’t until the GameStop (GME) saga that started in January that investors became more outspoken about PFOF and broker transparency.
Why PFOF should matter to investors
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.
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?
Possible issues with PFOF
Whenever profit is involved, it can be difficult to differentiate between what is right and wrong. For centuries, public companies have wrestled between doing what’s best for the company vs. what will give shareholders the highest dividend.
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 brokerages there is. That number was up from $892 million the year prior, meaning PFOF profits nearly tripled in just one year.
In just the second quarter of 2020, one household-name brokerage profited off of PFOF to the tune of nearly $70 million for equity and $112 million for options. That showed as much as a 122% increase in profit quarter-over-quarter.
Because some market makers will offer a higher monetary incentive to brokerages than others, there are times when a company may prioritize profit over what’s best for the end user making the trade. While brokerages are not legally upheld by the fiduciary standard, they are bound to the suitability standard, which states that transactions must be suitable for client needs.
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.
Why Public moved away from PFOF
Ever since PFOF received warranted notoriety back in early 2021, Public decided to stop participating in the payment for order flow process. Instead, we’ve introduced tipping.
By doing this, we knew we could remove conflict of interest from our business model, instead focusing on building a community we believe in to its core.
Trades will remain commission-free and tipping is entirely optional. Members of the Public.com community can freely decide if they’d like to leave a tip to help pay for the cost of executing their trades. With the help of our clearing firm, Apex, we are able to route all orders directly to exchanges (e.g. Nasdaq and the NYSE).
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. Despite this transition, we’re optimistic that we can offset this reallocation of funds with the optional tipping feature.
At Public, we promote thematic investing through verticals like Diverse Leadership, American Made, and Combat Carbon (just to name a few). We do this because we believe impact investing should be as simple as it is impactful. In many cases, PFOF has proven to go against a transparent investing environment, which means it goes against the positive impact that many investors have in mind when they envision a better world.
For that, we’re using tipping as a way to bridge the gap between our brokerage and the investors who we serve.
So how do you tip on an order through Public?
When executing a trade on the Public app, you’ll see a button that gives you the option to tip. You can tip as a dollar amount, and the funds are removed from your buying power. The tip only goes through once the order executes (like when the market opens or if the stock’s value is within the limit order).
Your choice of whether or not to tip does not impact your order execution. It is entirely optional.
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.