Payment for Order Flow –What is it, who does it, why it matters
The SEC defines payment for order flow (PFOF) as “a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.” This practice has been in the news lately, in part because of the recent scrutiny of trading practices at Robinhood – a firm which receives substantial payments for order flow as a function of their trade volume. Larger firms typically get a lower percentage, but the amount of revenue generated by these payments is substantial. According to Richard Repetto of Piper Sandler, TD Ameritrade received $324 million in payment for order flow in the second quarter of 2020 alone. If you’re curious about what this means and how it affects your investments, we offer a bit of history and context.
First, we need to understand what happens when a retail investor places an order to buy or sell stocks or options. In today’s complex marketplace, where thousands of stocks can trade on multiple exchanges, the order will generally be routed to a market maker, a high frequency trader who maintains an inventory of shares and options contracts. Examples include firms such as Citadel, Virtu, and Two Sigma. The market maker can decide whether to execute your trade themselves, or pass it on to a stock exchange for execution. Market makers profit from the difference between bid and ask prices, or the “spread.” They may also profit from having information about the volume of trades from retail investors. Since retail investors are generally thought to be less well-informed than institutional traders, market makers will often take the opposite side of the retail trade. Even if the market maker does not execute the trade themselves, they may use the trading data to bet against non-professional traders.
Let’s consider the potential advantages and disadvantages of payment for order flow from the point of view of the retail investor. Market makers benefit from the increased volume of shares, so they pay the brokerage firm for directing traffic to them, and brokers often pass those savings on to investors. This has reduced the cost of trading for retail traders, all the way to zero in many cases. Reducing the cost of trading is a good thing if it means more of your investment dollars stay invested, rather than paying trading fees. But how can the investor know that the order is being routed to a particular market maker for the investor’s benefit, or because it gets the broker a better deal on payment for order flow? There are some protections, discussed below, but the short answer is that this practice can create a conflict between the investor’s best interests and the broker’s.
Some history: The practice of payment for order flow was pioneered by Bernard Madoff in the 1990’s. The fees he paid for access to orders enabled brokers to reduce commissions, fueling the developing discount brokerage business. Although this practice was not related to Mr. Madoff’s fraud scheme, it has been controversial. Currently, most US brokers receive payment for order flow. The rare exceptions include Fidelity, Vanguard, Interactive Brokers, and Shareholders Service Group.
Where do our regulators stand on the issue of payment for order flow? The NASD investigated the practice in 1990, decided it was not illegal and recommended disclosures. In 2000, the SEC began to investigate payment for order flow, and considered banning it. In the end, the SEC also decided that disclosure was sufficient to protect investors. In 2005 the SEC published Regulation NMS (National Market System), seeking to refine how stocks are traded. Rules 605 and 606 requires brokers to disclose both execution quality and payment for order flow information. However, according to the Financial Information Forum, the 605/606 reports “do not provide the level of information that allows a retail investor to gauge how well a broker-dealer typically fills a retail order when compared to the ‘national best bid or offer’ (NBBO) at the time the order was received by the executing broker-dealer.” Regulation NMS does require that third parties who interact with client order flow must give the investor the NBBO or better. Unfortunately, there is no way for the investor to know if the price they received on a given trade was the best available price.
You can view an example report here, for TD Ameritrade: https://www.tdameritrade.com/retail-en_us/resources/606_disclosure/tdac-TDA2054-q4-2020.pdf
In countries where payment for order flow is not allowed, there is some evidence that retail investors receive better prices. In May of 2012, the UK’s Financial Services Authority issued a clarification of rules to indicate that payment for order flow is not permitted. The CFA Institute, a global association of investment professionals, published a paper in June 2016 analyzing the effect of that rule clarification in the UK market. They found that the proportion of retail-sized trades executing at best quoted prices between 2010 and 2014 increased from 65% to 90%, suggesting that the ban on payment for order flow improved the execution for retail investors. You can read the report here:
Who benefits the most from payment for order flow? While it’s true that this practice has reduced the cost of trading for retail investors, it’s also true that frequent trading can lead to poor returns, according to studies such as Barber and Odean (Graduate School of Management, UC Davis/Haas School of Business, UC Berkeley). In short, reducing the cost of trading does not necessarily improve the performance of investors’ portfolios, and may encourage over-trading which has been shown to degrade performance. At the same time, no-fee trading forces brokers to seek revenue elsewhere, in the form of payments for directing trade traffic. While these practices are disclosed, the format does not allow us to determine whether an individual investor got the best available price for any given trade.
At Empowerment Financial Guidance, we chose Shareholders Service Group as custodian for our clients’ funds for a host of reasons, many of which can be summed up by saying that they seemed to share our values and ethics. SSG has never received payment for order flow, because they believe it leads to potential conflicts of interest, and they want to keep their operations completely transparent. You can confirm this in their disclosure forms here:
https://www.orderroutingdisclosure.com/ Type in Shareholders Service Group to see disclosures.
Payment for order flow can create a conflict between the interests of the investor, who wants the best available price, and the broker who wants to maximize revenue in this environment of no-fee trades. Brokers are required to disclose what they are paid, but the information provided may not be sufficient for investors to fully understand whether they have received the best available price. In this era of no-fee trades with brokers receiving hundreds of millions of dollars each quarter in payments for directing their clients’ orders, we believe this practice deserves additional scrutiny.
