What is Payment for order flow and how to avoid it

A brokerage firm is compensated and receives benefits for directing orders to different parties.

What is Payment for order flow and how to avoid it

What is payment for order flow?

Third-party firms (mostly high-frequency trading firms) compensate brokerage firms for the right to access their order flow through payment for order flow.

As an example, if you enter an order to purchase 100 shares of Apple stock on Robinhood, you might think your order is routed directly to the stock exchange to be integrated with other active orders.

As a middleman between you and the stock exchange, a discount broker does not always have to send your order directly to the exchange, and in fact, most of them do not.

High-frequency trading firms (or “wholesalers”), such as Citadel Securities, receive your order and decide whether they want to execute it or pass it on to the open market.

The National Market System allows the acceptance of PFOF only if no other exchange can quote a better price. Clients must be notified that the broker accepts PFOF. It is imperative that transactions be executed with the best possible execution, which could mean the best price or the quickest execution time.

 Canadian brokers charge commissions because PFOFs are not allowed in Canada. 

The practice is also forbidden in the United Kingdom. Euronext reports that European authorities have regulated the practice, and it is permitted in a number of national jurisdictions across Europe.

Retail order flow is bought by the following firms:

  • Wolverine Securities
  • Two sigma Securities
  • G1 Execution Services
  • Virtu Financial
  • Citadel securities

History of payment for order flow

In the early days of the internet, Bernie Madoff used discount brokers to access orders before they were routed to the market, much like high-frequency trading firms do today.

Essentially, the start of this practice led to the development of discount brokerage, as the brokerages could use the fees Madoff paid them to lower their commissions.

Madoff predicted this in an interview with CNN Money in 2000, when financial markets became more digitized and more automation entered the market, lowering wholesalers' per-share prices.

CNN: Will payment for order flow ever disappear?

Madoff: ‘’No. I think it will get lower and lower as the spreads get lower and lower with decimals. No one tells a firm how they can advertise. If I want to hire salesmen to generate order flow, no one is going to object. I don’t have them. So if I want to use Fidelity’s salesmen and pay part of my trading profits in the form of a rebate, why shouldn’t I be allowed to do it? It was characterized as this bribe and kickback and something sinister, which was very easy to do. But 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. Order flow is an issue that attracted a lot of attention but is grossly overrated.’’

Conflict of interest

Market makers may not execute executable orders since PFOF causes them to be routed to those who pay the highest amount. Retail traders have little knowledge and less data than institutional traders.

How to avoid Payment for order flow

By using a broker who doesn't sell your order flow, you can avoid payment for order flow. Due to SEC regulations, brokers must state if they receive payments for order flow, and to whom they sell it.

Due to their business model designed to attract smarter retail traders, Interactive Brokers is the only large discount brokerage firm that doesn't receive payment for order flow. This would alienate their target market.

You can find their disclosure HERE 

Vanguard has also refused to sell their clients' orders for stocks and ETFs, but their tools are unlikely to be effective for active traders.

It is also possible to avoid having your orders sold to HFTs by finding a broker who offers direct market access. Your broker will not act as a middleman between you and the exchanges, and your orders can be sent through any route you wish.

Here are a few examples of brokers offering direct market access:

  • Lightspeed
  • Interactive Brokers
  • Speedtrader
  • Centerpoint Securities
  • TradeStation

 

 

References

En.wikipedia.org. n.d. Payment for order flow. [online] Available at: < https://en.wikipedia.org/wiki/Payment_for_order_flow#:~:text=Brokers%20in%20the%20United%20States,pro%20accounts%20that%20are%20charged >.

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