The Secret Weapon of Payment for Order Flow
While the digital age revolutionized most of the investing process for retail investors, the one legacy feature that held on for dear life was "commissions."
Traditionally, brokerages used commissions to charge consumers for access to the markets. Even as more brokers were conducting business online, popular brokerages were still charging $5, $10, even $20 per trade. That is, until an upstart named “Robinhood” came along with a new business model that changed the industry: commission-free trading. But this begs the question: How does Robinhood still manage to make money, despite not charging a commission?
That’s where the controversial revenue stream known as “payment for order flow” (PFOF) comes in. By making money through payment for order flow, brokerages can get away with not charging commissions, but this practice isn’t without controversy. In fact, the SEC determined that Robinhood’s use of PFOF from 2015-2018 “misled customers,”this method of revenue generation is so controversial that Robinhood attempted to obscure how much money they made via this process from 2015-2018, resulting in the largest ever fine doled out by FINRA.
So what exactly is PFOF, and why has it suddenly become a topic of conversation in investing circles?
What is Payment for Order Flow?
Strictly speaking, payment for order flow involves is the act of a market maker paying a brokerage for the exclusive right to execute their trades. As dry as that is, it’s pretty important to understand for the average retail investor.
The concept of payment for order flow actually isn’t new. Created by investing icon Bernie Madoff (yes, that same Bernie Madoff), payment for order flow was pioneered in 1991 as another way for large trading funds, known as “market makers,” to generate exclusive business with a brokerage.
The process is actually pretty straightforward: the market maker approaches a brokerage to be their primary trading house for buying and selling securities. The market maker, in return for this exclusivity, pays the brokerage fractions of a cent for each share they buy or sell. While that doesn’t sound like much, the volume of shares trading hands per day means that this payment to the brokerage can be millions, and millions, and millions of dollars.
While the brokerage is getting paid through the nose for this exclusivity, the market maker is benefiting on the other side by taking advantage of the difference between the buy and sell prices of securities. This difference is called the “bid-ask spread” and can be anywhere from fractions of a cent to several cents per share. Since the market maker handles both sides of the buy-sell transaction, they get to pocket the difference. Theoretically, the market maker is making a return on their investment on top of what they’re paying the brokerage, which is what makes payment for order flow appealing to both brokerages and market makers.
Arguments For Payment for Order Flow
Payment for order flow, in general discourse, is viewed in a…not so positive light. However, there are some valid arguments in adopting the practice.
The first is one we’ve already touched on: payment for order flow brings in additional revenue for the broker, which can allow the broker to eliminate commissions on trades. For Robinhood, this model generates a whopping 75% of their total revenue, which is how they were able to pioneer the "zero commission" business model that popularized their platform in the first place. This is obviously great for the end user, who doesn't have to pay hefty fees every time they want to execute a trade.
The second argument in favor of payment for order flow is that it helps to generate liquidity in the market. Like toilet paper in 2020, you can’t buy a stock if the inventory is unavailable. By acting as a middleman, market makers argue that they provide the necessary liquidity in the market required to keep shares moving. This is especially true in the options market, where high volumes of contracts change hands every minute.
Arguments Against Payment for Order Flow
Detractors of the payment for order flow model have some points of their own. Namely, that the routing of orders to a specific market maker creates a conflict of interest in the execution of the trade.
This could lead to investors not necessarily getting the best prices on their trades, since the buying and selling is running through the same market maker, and that market maker is looking to make money on the spread. It could also create issues if the market maker is put in a tough position, like what happened in early 2021.
Payment for Order Flow In The 2021 Memestock Trade
Nowhere was the payment for order flow conflict of interest more apparent than in the memestock revolution of 2021. For those of you that lived in a Faraday Cage at this time, members of the subreddit “Wall Street Bets” banded together to buy shares of GameStop and AMC Theaters, in an attempt to cause a historic short squeeze that damaged short holders. It even drove one hedge fund completely out of business.
Related: The 6 Best Investing Subreddits
It was at this time that Robinhood, one of the brokerages favored by the memestock traders, turned off the buy function for some of these stocks. This deeply upset traders, and many accused Robinhood’s market maker, Citadel, for being behind this, halting all trading activity on these stocks and costing retail investors millions of dollars, keeping the hedge funds at the top of the food chain.
Both Robinhood CEO, Vlad Tenev, and Citadel CEO, Ken Griffin, hauled in front of Congress where…not much happened. Over 30 class actions lawsuits were filed against Robinhood, which now stand at 34 separate cases as of April 2022. However, several of these claims are being dismissed by federal courts.
Congress also held a second hearing on the payment for order flow aspect of the matter, which eventually led new SEC Chairman, Gary Gensler, to further discuss “the future” of PFOF revenue. — leading some to wonder if PFOF will be made illegal.
What Is The Future of Payment for Order Flow?
At the end of the day, interacting with payment for order flow is not a necessary evil of online investing. While companies like Robinhood, E-Trade and Ally do engage in this practice, other brokerages, like Public.com, Fidelity and Fennel, do not.
The answer here is that each person will view payment for order flow differently, so it’s up to you to do your own research and determine which platform is right for you.
A previous version of this article was published on www.fennel.com.
Ah, the thrill of keeping track of 10,000 items in your e-commerce store… except, not really, because manually managing inventory is more of a nightmare than a thrill. But imagine if you had an invisible assistant that did it for you. Enter Priceva, the superhero of real-time stock tracking. This tool doesn’t just track; it tracks in real-time, which is basically the equivalent of having X-ray vision for your stock. With updates rolling in multiple times a day, you’ll never be caught off guard by an “out of stock” message again. And the notifications? They’re faster than a hungry kid reaching for candy 🍬. It alerts you when your stock levels are dipping low, making replenishment a breeze. Plus, the…