Payment for Order Flow and Regulatory Debates

Payment for order flow (PFOF) is a practice where broker-dealers receive compensation from market makers for directing customer trades to them instead of public exchanges. While legal, it creates incentives that may conflict with investors’ best interests. This workflow affects execution prices, spreads, and transparency—key factors in trading outcomes. Retail investors often encounter PFOF through discount brokers, making it essential to evaluate its impact on their trades.

The debate centers on whether PFOF enhances market liquidity or distorts price discovery. Brokers argue it subsidizes commission-free trading, while critics claim it reduces price competition. Regulatory scrutiny has intensified as PFOF volumes grew to over $10 billion annually in recent years. Understanding this dynamic helps investors assess execution quality and advocate for fair practices.

Definition and key concepts

Payment for order flow occurs when a broker routes customer orders to a market maker (instead of an exchange) in return for a financial rebate. The rebate typically equals a fraction of the bid-ask spread—the difference between the highest price buyers are willing to pay (bid) and the lowest price sellers will accept (ask). For example, if a stock’s spread is $0.05 ($150.00 bid, $150.05 ask), the market maker might pay the broker a rebate of $0.01 per share.

Key terms include:

• Market makers: Firms that provide liquidity by quoting both bid and ask prices.
• Soft dollars: Compensation that may influence order routing decisions.
• Rebates: Payments from market makers to brokers for prioritizing their orders.

The practice is governed by SEC rules like Rule 606, which requires brokers to disclose routing practices. However, critics argue these disclosures lack granularity to assess true impact.

How it works in practice

When a retail investor places an order through a commission-free broker, the broker may route it to a market maker instead of an exchange. The market maker executes the trade at the quoted price and pays the broker a rebate. Brokers use these rebates to offset operational costs or fund zero-commission trading.

For example: A broker executes 100,000 average daily equity trades. If 70% are routed to market makers with an average rebate of $0.003 per share, the broker earns $210 daily. This revenue model has become central to the business of brokers like Robinhood and Charles Schwab.

The investor’s execution price may be less favorable than the midpoint of the spread. If a stock has a $0.05 spread and the investor pays the ask price, they effectively bear the cost of the rebate ($0.01 in the earlier example) through wider execution prices.

Worked example: The hidden cost of routing

Consider an investor buying 100 shares of XYZ Corp at $150.05 (ask price). The bid price is $150.00, creating a $0.05 spread. A market maker offers the broker a $0.01 rebate per share for routing this order. Here’s the math:

• Investor cost: 100 shares × $150.05 = $15,005
• Market maker’s profit: 100 shares × $0.05 spread = $5
• Broker rebate: 100 shares × $0.01 = $1

The investor pays the full ask price. The broker earns $1, and the market maker keeps $4. If the order had gone to an exchange, the spread might have been narrower ($0.02), saving the investor $3. This illustrates how PFOF can indirectly raise transaction costs.

Risks, limitations, and tradeoffs

The primary risk is conflicted order routing. Brokers may prioritize market makers offering higher rebates over those providing better execution prices. In 2022, the Senate held hearings on whether PFOF compromises best execution standards, noting that 70-80% of retail orders are routed this way.

Limitations include:

• Reduced price competition among liquidity providers
• Potential for wider spreads on frequently traded stocks
• Opacity in how rebates correlate with execution quality

Regulators face a tradeoff between encouraging liquidity provision and ensuring fair execution. The SEC’s proposed reforms aim to require brokers to disclose rebate amounts and compare execution quality across venues.

Checklist and next steps

Use this framework to evaluate PFOF’s impact on your investing:

• Review your broker’s Form CRS and Rule 606 disclosures to understand order routing practices
• Compare execution prices for frequently traded stocks across brokers
• Consider using limit orders to control trade price, especially for high-volume stocks
• Advocate for transparency in rebate structures and best execution standards

Next, research how different brokers prioritize execution quality versus rebates. For active traders, comparing the average spread width and rebate rates across platforms can reveal hidden costs. For long-term buy-and-hold investors, the impact may be smaller but still worth monitoring.