What Exactly is Payment for Order Flow?

Ever since Robinhood was in the news back in January for their involvement in the GameStop controversy, the way brokerage firms get paid has come into question. Popular stockbrokerage companies such as Robinhood, Webull, E*Trade, and TD Ameritrade all utilize a practice that is known as “payment for order flow”. Payment for order flow is the process where the stockbrokers receive payments from the market makers (dealers) for routing trades to them. The brokerage firm is essentially acting as the middleman between you (the retail investor) and the market makers.

Who are the market makers? The bigger market makers are Citadel Securities, Susquehanna, Virtu, Two Sigma and UBS. The SEC defines a “market maker” as a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price. Market makers are essentially companies or individuals that buy up large quantities of stocks to sell hoping to make a profit on the bid–ask spread, or turn.

The market makers profit from buying shares for cheap and selling them for more expensive. The brokers on the other hand profit through making the trades actually happen by acting as the wholesaler between retail investors and market makers. The broker basically directs traffic to the market maker that can best fulfill the order. The stockbrokers will generally have prearranged agreements with market makers who will compete for the order flow.

The controversy with the payment for order flow process comes into play here. While the brokers should choose the market maker that will quickly and efficiently fill the order at the lowest market price, this isn’t always the case. An order flow agreement might make brokers direct traffic to a prearranged third-party. The third party compensates the broker for sending traffic their way, often at the expense of the retail investor.

One of the biggest worries with payment for order flow is that the brokerage firms might be routing orders to a particular market maker for their own benefit and not in the best interest of the the investors. Other concerns are that order flow arrangements empower market makers with the additional liquidity to bundle large orders, deal from inventory, and take the opposite sides of trades to buffer exposure risk.

Payment for order flow has been considered revolutionary for retail investors because it has all but eliminated the commissions and fees associated with trading stocks. But some argue that the negative consequences caused by the payment for order flow process outweigh the benefits of not paying commissions and fees. What are your thoughts about payment for order flow? Leave me a comment and let me know.

Photo by Vance Alm