Payment For Order Flow & Front Running
Payment for Order Flow (PFOF) is a practice in the financial industry where brokerage firms receive compensation from market makers or trading firms for routing their customer's orders to them for execution. Instead of sending the orders directly to stock exchanges, the brokerage firms route the orders to these market makers or trading firms. In return, these market makers provide compensation to the brokerage firms.
Here's how Payment for Order Flow works:
1. Customer Places an Order: When an individual places a buy or sell order for a stock or other financial instrument through a brokerage platform (ie Robinhood), the brokerage is responsible for executing that order.
2. Brokerage Routes the Order: Instead of sending the order to a traditional stock exchange (ie New York Stock Exchange or NASDAQ), the brokerage routes the order to a market maker or trading firm that participates in Payment for Order Flow agreements.
3. Execution by Market Maker: The market maker or trading firm executes the order on their own trading platform. They attempt to match the order with existing orders in their system and execute the trade.
4. Compensation to Brokerage: In exchange for directing customer orders to them, the market maker or trading firm pays a fee or compensation to the brokerage firm. This compensation can vary and is typically based on the volume of orders being routed.
Supposed benefits of Payment for Order Flow:
1. Lower Costs for Retail Investors: Brokers often claim that PFOF helps keep trading costs low for retail investors. By receiving compensation from market makers, brokers might offer commission-free trading to their customers.
2. Faster Execution: Market makers often specialize in executing trades quickly and efficiently, potentially leading to faster execution for retail investors' orders.
Critiques and Concerns:
1. Conflict of Interest: Critics argue that PFOF can create a conflict of interest for brokers. If a broker's revenue is tied to directing orders to specific market makers, there might be an incentive to prioritize the broker's financial interests over getting the best execution for customers.
2. Transparency: There are concerns about transparency. Some believe that PFOF might not be fully transparent to customers, potentially leading them to believe that their broker is providing the best possible execution when other options might exist.
3. Best Execution: The practice raises questions about whether orders are being executed at the best possible prices. In some cases, routing orders to market makers might not result in the most favorable outcome for the customer.
To better understand how PFOF works, lets look at the following analogy:
Imagine you're at a farmers' market, and you want to buy some fresh fruits. You go to a booth that represents a brokerage firm. Instead of directly going to the fruit vendors which would be the stock exchange, the brokerage firm takes your fruit order and sends it to a few different vendors who are part of an agreement. These vendors are like the market makers or trading firms in the financial world.
Each vendor then checks their available fruit and offers to sell you the fruits at different prices. The brokerage firm considers these offers and picks the vendor that they see fit. The market maker goes out and fufills your order for you. While doing this, they might buy the fruit at say $1.50 a pund and then sell it back to you at $1.52 per pound. If you went out to the market yourself (your order went straight to the exchange) you could have gotten the $1.50 price for yourself.
This practice of sending your order to the different fruit vendors and getting paid by them for doing so is similar to Payment for Order Flow in the financial world. The brokerage firm is like the middle person, and the vendors are like the market makers. The brokerage firm makes some money from the vendors for sending them orders, and in exchange, they aim to get you the best fruit deal possible.
Payment for order flow is system that is built upon back room deals and a lack of transparency. In the principal, it is against democratic finance. In addition to this, users get a worse fill price than they would have normally gotten if their order went straight to the exchange.