- Payment for order flow (PFOF) is the compensation brokerages earn by having third-party firms execute client orders.
- Payment for order flow can impact an investor's final per-share cost, especially if they trade actively.
- Though PFOF can affect costs, it doesn't jeopardize your transactions or account security.
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In early 2021, online investment apps like Robinhood started getting scrutinized for a behind-the-scenes system called payment for order flow (PFOF). The process involves them routing stock or other trade orders from their clients to outside firms, who actually carry out the trade. These third-party companies pay your broker for routing your order to them.
While not all commission-free brokerages utilize this compensation arrangement, it's a common practice among discount brokerages like E*TRADE, Webull, and others.
It's a business-to-business arrangement. But the entire transaction can impact the final per-share cost for the investor.
Luckily, this is something that retail investors don't have to be in the dark about, thanks to the US Securities and Exchange Commission's (SEC) Rule 606. This rule requires brokerages that use PFOF to provide public disclosures on their order routing practices on a quarterly basis.
Keep reading to see how payment for order flow (PFOF) works, and how it could affect your investments.
What is payment for order flow?
Also known as stock order routing, PFOF is a process whereby online brokerages rely upon high-frequency trading (HFT) firms, or market makers, to execute stock and option investment transactions. This means your orders aren't being directly executed by your broker, but by a third party. Since market prices rapidly fluctuate for stocks, you could end up paying a price that's slightly higher or lower than what you'd initially bargained for.
- If your stock trades in an over-the-counter (OTC) market, the brokerage can sell the order to an OTC market maker firm that executes your order
- Brokers can also route orders to electronic communications networks (ECNs) that can match buy or sell orders at certain prices
- Your broker may execute trades through a process known as internalization. This allows your investment app to send your order to another division of its company for execution. The firm profits due to the difference between what they paid for the security and what they're selling it to you for
If you'd like to learn more about market makers' order routing and order execution practices, you can generally find public disclosures on their websites, thanks to SEC Rule 605.
How payment for order flow works
When your broker sends a stock or option order to a market maker, the third-party firm pays the brokerage to execute it.
For instance, if you placed a buy order for 20 shares of Amazon (AMZN) stock with a brokerage that receives PFOF, your order will make a pit stop before it gets fulfilled. After you place the order, your brokerage will send it to a market maker who carries out the actual trade.
Does it mean your free trade isn't really free?
That depends on how fast the securities markets are moving. If you're interested in buying a hot stock whose prices are rapidly rising and falling, there's no guarantee that the amount you paid per share will be the same price at which the order is executed.
In other words, HTF firms have the power to determine when your order goes to the markets. Generally, it's in their best interest (as well as yours) to execute the trade as quickly as possible.
Still, if a stock's price changes by the time your order is fulfilled, you could end up paying more or less per share.
However, if you're looking to buy a less volatile stock, you may not have to worry about a price change at all.
Should you choose an investment app that sells your orders?
Dropping an app or brokerage that uses PFOF is ultimately up to you to decide. Keep in mind that PFOF doesn't compromise the security of your investment account, nor is the money in your brokerage account being held hostage against your will. The trade you want will happen. It's the exact timing of the transaction that's affected, which then could affect the price you buy or sell the stock for.
The financial takeaway
Payment for order flow is the money a brokerage or investment app receives when they pay an outside firm to execute the investment buy or sell orders you gave them. This procedure gives the market maker firm the power to carry out your trades.
Many discount brokers and commission-free investment apps utilize PFOF to earn additional compensation, but it doesn't affect your investment choices or account safety. If you're an active trader or day trader who regularly invests in options, PFOF might impact the final costs of your trades since the third-party firms do have some control over the speed of your order's execution.
In short, the effect of PFOF on most ordinary investors is limited. Still, if you're not in love with the idea of your transactions being farmed out, though, you may want to consider other brokerages - such as Fidelity, and Interactive Brokers - that don't use this compensation arrangement at all.