This article by Rafi Reguer of Forefront Communications explains Payment for Order Flow (“PFOF”) has been in the news quite a bit since the GameStop/Reddit/Robinhood story hit the news several weeks ago. And it seems like it’s about to get a lot more attention later this week when the House Financial Services Committee convenes a hearing in which the CEOs of Citadel, Robinhood and Reddit are expected to testify.
At a basic level, PFOF is fairly easy to understand, even for novice investors. You place an order to buy or sell some stock with your brokerage firm. That broker has many choices as to where to route that order for execution. Some venues, like stock exchanges, charge your broker to execute those trades; other venues, like private trading platforms, pay your broker for the opportunity to execute those trades. When your broker routes your order to a place that pays them, the money they receive is referred to as payment for the flow.
See? That was easy.
The trick is to understand PFOF in context. You can’t really have an informed opinion as to whether it is good, bad or neutral unless you understand it within the broader context of how the stock market works. Before looking at the arguments for and against PFOF, there are six concepts you need to understand.
INVESTORS VS. TRADERS
At any given time during the trading day, there are people buying Apple stock. Some will hold on to the stock for a decade; others will have sold the shares in less time than it takes for you to read this sentence. In other words, some are investors and some are traders.
Putting aside the argument about what length of time one needs to hold an asset to go from being labelled a “trader” to an “investor,” it’s fair to say there has always been tension between these two groups. Whether the assets being traded are stocks or cattle futures, investors are always deeply suspicious that traders are ripping them off. You can find newspaper quotes from people going back hundreds of years questioning the validity and morality of people whose entire business is making money by simply “flipping assets,” buying them at one price and selling them at a slightly higher price. Investors feel more comfortable in a “natural” market, where a buyer and a seller are paired off, with no middleman. The problem is that natural markets aren’t necessarily very efficient or liquid. If you want liquidity, you need different kinds of people and firms with different goals, different strategies and different time horizons.
Ideally, if you want liquidity and efficiency, you need people or firms willing to buy and sell assets all day long. You need trading firms that are market makers.
In simple terms, a firm that makes a market in a stock is willing to buy or sell that stock at any time. A market maker offers a two-sided quote, a bid at which they are willing to buy the stock and an ask at which they are willing to sell. For example, let’s say that a market maker is quoting $12.00 by $12.10 for Stock A. If you want to buy Stock A, the market maker will sell it to you at $12.10. If you want to sell Stock A, they will buy it at $12.00. That 10-cent difference is called the spread. Market makers stay in business by pocketing that spread. With spreads being only pennies, the market makers have to do lots of trading, so they value order flow.
Let’s say you own a retail brokerage firm. You receive a client order to buy 100 shares of Stock A, and then you immediately receive an order from a different client to sell 100 shares of Stock A. What happens now? If you’re in Canada, by rule, you must send both orders to the stock exchange. In the United States, you have other choices. You could route the order to a market maker, as described above, but we’ll deal with that choice later. The choice we’ll talk about here is “internalization,” matching the order yourself and letting the stock exchange know that the trade happened.
Why internalize? It’s a better choice than routing to the exchange because the exchange will charge you a fee for executing each side of the trade, but it’s free if you do it yourself. If you run a big brokerage firm that has many clients buying and selling, internalizing some of your order flow can represent quite a savings.
SURPRISE: THE TERMS ARE USED INTERCHANGEABLY
Within the industry, the terms “market maker” and “internalizer” (also “wholesaler”) are often used interchangeably. How can these terms be synonymous if they have different definitions?
Well, over the years, these activities have bled into each other. And the relationships between firms and units of firms are blurrier than they once were. Let’s explore that.
So, if you remember from earlier in the article, you own a brokerage firm (Congratulations, by the way—I’m sure a lot of theoretical hard work went into your success). You internalize orders, matching simultaneous buys and sells. But if internalization is something that really helps your firm, it must really, really help firms larger than yours. Firms that do substantially more trading can internalize a higher percentage of trades and probably run you out of business. Now what do you do?
First, you could expand from matching simultaneous orders to offering a two-sided quote by running a market-making operation within your brokerage firm. You can internalize a lot more orders if you’re making a market in the securities your customers buy and sell.
Of course, you still may not be able to compete your largest competitors if they’re doing the same. Fortunately, there are probably a lot of other retail brokers in the same boat you are. That brings us to a second option: instead of being limited to matching orders within your own firm, you and some of your competitors could all route to one that specializes in market making. That one may even make enough money from market making that it can offer you PFOF.
In reality, various versions of these ideas exist throughout the industry. About 30 years ago, discount brokerage firm Schwab bought a market maker and began sending the vast majority of its order flow to its new business unit. At the same time, a consortium of Schwab’s competitors, mostly discount brokerage firms, pooled their money to create a new market maker, Knight Capital Group (now part of Virtu), so they could route their order flow to an entity they jointly owned. Various full-service brokers run a variety of in-house trading platforms, some of which permit order flow from other firms. For example, Robinhood routes most of its order flow to Citadel in exchange for PFOF. Understanding that there are numerous order flow arrangements is critical to understanding the PFOF controversy.
Now that we have a handle on the perquisites for routing order flow to various off-exchange trading venues, let’s see what the customer gets out of it.
Sticking with the prior example, let’s assume that at the time you received the simultaneous buy and sell orders, the price for Stock A was $12.00 by $12.10. You don’t want to send the orders to the exchange and pay a fee, so you send them to an external market maker. The maximum spread is $0.10, but in this case, the market maker matches the orders and executes the purchase at $12.09 and the sale at $12.01. The market maker keeps 80% of the spread, and both buyer and seller get an extra cent per share. This is known as price improvement.
- The market maker made $0.08 from the spread.
- Your brokerage firm saved the fee of sending the orders to the exchange and received PFOF from the market maker (which comes out of the money it made on the spread).
- Your customers got a price better than what was displayed in the public market.
Everyone wins! Well, maybe not everyone. The entities directly involved win, but some would argue that having this trade occur off-exchange harms the market overall. That’s part of the PFOF controversy.
OK, one last concept to learn: best execution.
By SEC rule, brokerage firms are required to get, in the aggregate, the best possible trade execution for their customers’ orders. Furthermore, the SEC requires brokerage firms to continuously monitor to ensure they are in fact getting “best ex,” as well as make public where their orders are routed. Sounds simple enough, but since it’s impossible to know what the execution price would have been had a bunch of theoretical things happened differently—for example, if all orders interacted on exchange and not off—it is extremely difficult, if not impossible, to definitively identify the “best” possible execution.
PUTTING IT ALL TOGETHER
Fast-forward to 2021: GameStop/Reddit/Robinhood is all over the headlines, and among the myriad issues being scrutinized is PFOF.
THE ARGUMENTS AGAINST PFOF
ARGUMENT A: It’s pretty simple. A brokerage firm has an obligation to get its clients the best execution possible, so an incentive to route trades to one venue over another kind of seems like a bribe to get the firm to ignore that obligation. Even if investors receive price improvement, it’s possible that without PFOF, their brokerage firm might have routed to a trading venue that offered even better price improvement.
ARGUMENT B: A second argument against PFOF is that it segments the market in a way that harms the market overall. PFOF offers incentives that result in nearly all retail flow being routed off-exchange (though that may be changing). With that order flow missing from public exchanges, there is less liquidity for large institutional investors to interact with, which a recent analysis from GTA Babelfish claims increases trading costs. Exchanges are also where “price discovery” happens, meaning that having buyers and sellers interact on a public venue lets everyone see what the true price of an asset is. Market participants cannot see all the buyers and sellers when off-exchange trading occurs, which has been accelerating of late—see the recent twitter thread from Rosenblatt Securities’ Justin Schack for a detailed analysis of the ramifications of this. Amazingly, the trading venue that currently processes the most trades isn’t a stock exchange; it’s a market maker.
THE ARGUMENTS FOR PFOF
The three counterarguments to ARGUMENT A:
- Regardless of which side of the argument you’re on, there seems to be general agreement that PFOF is at worst neutral and most likely a positive for retail investors (at least those trading directly—those invested via a fund manager we’ll put aside for the sake of argument).While some will argue about how the price improvement they receive is calculated and how trades for a small number of shares or fractional shares don’t get it, no one argues that they are not improved or that they’ve been harmed in any way.
- Second, PFOF has enabled brokerage firms to democratize trading by allowing accounts with no minimums, no commissions, trading fractional shares, etc. If the practice is outlawed, the money still has to come from somewhere. That brokerage firm you own isn’t a non-profit, is it? Even if it were, the overhead for running a broker-dealer is quite substantial. Either commissions have to be raised significantly or something else has to be worked out. Whether explicitly or implicitly, the retail customer is going to have to pay for trading.
- Third, brokerage firms already have best execution requirements and must monitor and disclose their routing practices. On its face, PFOF may sound troubling, but if you dig down a little, the regulations do address it. And if there are still some issues, the SEC should be able to address those by tweaking the best execution requirements, rather than outlawing PFOF altogether.
The counterarguments to ARGUMENT B:
If the premise is that off-exchange trading is harming the overall markets, then why limit the discussion to PFOF? That’s only one piece of the puzzle. PFOF affects retail trading, but we cannot forget about institutional trading. Institutions often trade large blocks of stock on off-exchange venues run by large brokerage firms. What about those large firms that internalize to all kinds of trading venues (crossing networks, dark pools, market-making operations, etc.)? They are certainly meeting the needs of institutions seeking “natural” trading partners, but that order flow is also going away from exchanges. If off-exchange trading harms liquidity and price discovery, then the scrutiny and reforms shouldn’t be limited to PFOF.
If only PFOF is curbed and everything else remains, there will be consequences, both expected and unexpected. It would most likely tilt the playing field in favor of large firms. Inevitability, that will lead to further consolidation within the industry, thereby reducing the number of choices available to retail investors.
The final counterargument to both A and B is this: we have been down this road before . . . numerous times. The PFOF controversy rears its head every few years. The SEC has already looked into this multiple times. It ruled in 1994 that while PFOF does raise the potential for a conflict of interest, it does not violate best execution requirements. As part of a 2016 Memorandum to the Equity Market Structure Advisory Committee, the SEC’s Division of Markets and Trading addressed everything mentioned above. While the elimination of PFOF was mentioned as a possible option, the SEC did not choose that option. The amount of PFOF has grown since 2016, but the issues are the same.
So, that’s payment for order flow, in a nutshell. We will see how the 2021 version of this debate plays out. But at least you now have a basic understanding of some market structure details, what the arguments around PFOF are, and, at least in theory, your very own brokerage firm.
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