Why payment for order flow should be banned
- December 15, 2021
- Reading time: 4 minutes
Payment for order flow was not common knowledge for most stock traders. Until we saw the 2021 GME short squeeze. GME went from $5 to $400 in a matter of weeks. All of a sudden retail traders realized that their broker is not their friend. 80% of trading took place in Dark Pools where nobody has access to, other then banks and institutions. Thanks to the huge efforts of Reddit forum member and You tubers, PFOF is a toxic and the rumour is that it will be banned soon.
What exactly is payment for order flow?
Payment for order flow is the compensation that brokerage firms receive by routing orders to different avenues for trade execution. The firm usually receives a small payment, which could be fractions of a penny per share, for directing orders to different market makers. This practice is much more prevalent in options trades since there are thousands of possible contracts in existence. PFOF has been in existence since at least the 1990s.
Many brokers chose the zero commission model where they offer trading “for free” in return for huge payments for sending their order flow to a market maker first. Robin Hood is a good example of a “zero commission” broker.
What is a market maker?
Market makers are typically electronic trading firms. They buy and sell shares all day long, trying to profit from the bid-ask spreads. The market maker profits can execute trades from their own inventory or in the market. Offering quotes and bidding on both sides of the market helps to keep markets liquid.
Market makers that execute retail orders are also called wholesalers. The money that market makers collect from PFOF is usually fractions of a cent on each share, but these are reliable profits that can turn into hundreds of millions in revenue a year. In recent years, a number of firms have exited or sold their wholesaling businesses, leaving just a handful of electronic trading firms that handle PFOF.
In addition to profits from stock spreads, the orders from brokerage firms give market makers valuable market data on retail trading flows. They know exactly where a buy or sell range is by simply looking at all the limit orders. When it comes to using institutional or retail investors, market makers also prefer trading with the latter because larger market players like hedge funds can trade many shares at once. This can cause big shifts in prices, hitting market makers with losses.
Market makers getting richer and richer
Equity and options trading has become increasingly complex with the rise of exchanges and electronic communication networks (ECNs) What is extra ironic is that payment for order flow is a practice pioneered by Bernard Madoff , the world’s most famous Ponzi scheme artist.
The Securities and Exchange Commission (SEC), currently led by Gary Gensler said, in a special study on PFOF published in December 2000, “Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.” How wrong could they be?
Given the complexity of executing orders on thousands of stocks that can be traded on multiple exchanges, the practice of being a market maker has grown over the last decades. Institutions are always looking for ways to trade risk free.
Probably the most famous (notorious) Market maker must be Citadel. Hated by the so called “Ape army” who are led by guys like you and me, craving for deep intel and sharing this information via numerous platforms, such as Reddit, Twitter and Youtube.
Greed blossoms everywhere and Bloomberg reports that Citadel Securities doubled revenues to a record $6.7bn last year, and made a record $4.1bn in earnings before interest, taxes, depreciation and amortization.
How does payment for order flow work?
See the image below where it explains how payment for order flow works. As you can see, your order is NOT going to exchange before it hits the server of a market maker.
Typically these market makers use complex trading algorithms to manage the flow. How cute to know exactly what price you are willing to buy a stock where a trading algo tries to find the stock for a better price and fills you for you limit. A 100% risk free trade for a market maker. This is just one example of how this business model is so popular amongst the bankers and hedgies.
Hopefully you will think again before trading with a broker that offers commission free trading. These brokers are NOT your friend. They just facilitate a very toxic way of making money at your expense.
In the United States, accepting PFOF is only allowed if no other exchange is quoting a better price on the National Market System. The broker must disclose to the client that it accepts PFOF. Transactions must be executed at the best execution, which could mean the best price available or the speediest execution available.
How to prevent your orders from going to market makers first?
Actually this is rather simple.
First you can of course opt for a broker that does not support the so called PFOF model. Examples are Fidelity and Interactive Brokers. Although with interactive brokers you should disable the order routing.
Another way to send your order directly to the exchange (Lit Exchange), many brokers offer you a feature to enable or disable this.
Conclusion
In the last decade many brokers to adopt the payment for order flow business structure. Due to low commissions its pretty much a no brainer. PFOF is now a major revenue source for brokers.
For the retail investor, though, the problem with payment for order flow is that the brokerage might be routing orders to a particular market maker for their own benefit, and not in the investor’s best interest.
Investors who rarely trade or trade with very small quantities may not feel the effects of their broker ’s PFOF practices. But day traders and those who trade larger quantities should learn more about their broker’s order routing system to make sure that they’re not losing out on price improvement due to a broker prioritizing payment for order flow.
We hope the US will follow Canada and or the UK where PFOF is banned. Europe is already discussing a ban and it’s expected to be approved. Many brokers lost their focus on their mission, which is to always give the best price to their clients.
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