Payment for order flow: How it works and why it matters

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Trade orders flow from brokerages to market makers.

© CHUNYIP WONG—E+/Getty Images

There’s a relatively new thing in the retail trading world called zero-commission trading. As far as what it offers, the name says it all—you can place trades commission-free. Still, brokerages need to make money for the services they provide. So if they’re not getting compensated through commissions, then how are they making money?

Well, they earn interest from customers’ cash held on their books—and from margin lending—and some brokers offer add-on and premium services.

But for most of the top retail brokers in the U.S., another revenue source is payment for order flow (PFOF).

Let’s step outside the retail trading world for a moment and just think about how businesses generally market and sell their merchandise. Many businesses pay referral fees to individuals or other businesses for sending customers their way. It’s like an incentivized marketing tool.

Going back to the world of retail trading, PFOF works in a similar way. Payment for order flow is compensation received by a brokerage firm for routing retail buy and sell orders to a specific market maker, who takes the other side of the order. (In other words, market makers become the seller to your buy order or buyer to your sell order).

Payment for order flow is prevalent in equity (stock) and options trading in the U.S. But it’s not allowed in many other jurisdictions, such as the U.K, Canada, and Australia. In early 2023, the European Union announced a planned phaseout of PFOF in member states that currently allow the practice.

So is PFOF a healthy facilitator of the market’s march toward lower transaction costs? Or does it create a conflict of interest among brokers who have a duty to provide best execution for client orders? For some, this is an open question (see below).

The concept of “payment for order flow” started in the early 1980s with the rise of computerized order processing. Market makers would share a portion of their profits with brokerages that routed orders directly to them.

This business model is used in many different industries, not just investments. For example, in retail merchandising, a distributor or manufacturer might pay to have their products displayed prominently on store shelves. Similarly, a bank might offer a fee to someone who brings in new customers. If you subscribe to one of those meal-kit providers, you’ve probably been given a voucher for free meals (or even money) for signing up your friends.

In other words, offering financial incentives to an entity that helps you generate profit is a fundamental tenet of capitalism.

Regulations require that brokers fill orders at what’s called the NBBO (National Best Bid and Offer) or better. The NBBO is the tightest quoted spread between the bid and the ask price of an option contract or shares of stock from all the exchanges (e.g., the New York Stock Exchange, Nasdaq, and others) as calculated by an integrated system of Security Information Processors (“SIPs”).

For actively traded stocks and options, the NBBO may be a penny or two. For less actively traded securities, it could be a bit wider.

Suppose you (as a retail investor) pull up a quote on stock XYZ, with the intention of buying 100 shares. Let’s say the NBBO is a bid of $101.02 and an offer of $101.08.

If you were to enter a market order to buy 100 shares, you should be filled at a price of $101.08 or lower. A person selling at that same moment would expect a price of $101.02 or better. Market makers—who buy and sell millions of shares on thousands of securities each day—take a little bit of risk, and earn a little bit of theoretical profit (what traders call the “edge”), because participants need to cross the bid-ask spread in order to trade.

Because retail order flow is seen as the bread and butter of the market maker’s operation, it’s in the market maker’s best interest to attract that order flow. Hence the compensation or “payment” they may offer to brokers for that order flow.

Payment for order flow has evolved greatly, to the benefit of the retail stock and option trader—at least, in terms of reduced commissions.

In the U.S., many retail brokerage firms that participate in payment for order flow programs have eliminated their transaction commissions on stocks, ETFs, and options to $0 for their customers. (But note: Some transaction costs, such as exchange fees on option trades, still get passed on to customers.) This significantly reduces trading costs for retail investors compared to just a few years ago.

Citadel Securities, Susquehanna International Group, Wolverine Capital Partners, Virtu Financial, and Two Sigma are among the largest market makers in the industry. And the top three within that group—namely, Citadel, Susquehanna, and Wolverine—account for more than 70% of execution volume in the markets. These and other market makers use high-frequency algorithms that scan exchanges to compete fiercely for orders.

As a retail investor, you can benefit from price improvements on your buy and sell orders. This simply means that if a market maker can fill your order inside the best bid and offer (NBBO), they will do so and pass the savings on to you.

You can also send limit orders (orders that must be filled at a specific price) that are “inside” the quoted best bid and offer. Many top brokers report high levels of price improvement—on as many as 90% of their orders. It might be a penny (or even a fraction of a penny) per share, but improvement is improvement.

Perhaps the biggest concern with PFOF is that it could create a conflict of interest for brokers, as they might be tempted to route an order to a specific venue to maximize payment rather than to get the best execution for the customer.

PFOF came under fire during the 2021 “meme stock frenzy.” The same electronic message boards that helped drive the trading volatility in stocks such as GameStop (GME) and AMC Entertainment (AMC) were the source of speculation that market makers—who had orders routed to them through PFOF agreements—were directly trading against their orders and front-running (that is, trading for their own principal accounts at a better price, filling the customer at a worse price, and pocketing the difference). This, of course, is illegal. But with multiple trading venues and when trades are matched within milliseconds, it’s not easy to prove (or disprove).

There have also been questions surrounding the accuracy of price improvement data, as much of it is compiled by the brokers themselves.

Despite the rationale and mechanics of PFOF (and the fact that bid-ask spreads—and commission costs—have continued to fall) the practice was cast in a negative light by the media, and alarm bells were raised with regulators. Some—including SEC chair Gary Gensler—floated a potential ban of the practice.

The execution of retail trading orders has evolved greatly over the last 20 years. Costs for active traders have come down dramatically, to the benefit of investors. Brokerage firms and investors could survive without a system of payment for order flow, as many do in other countries, but if margins shrink for brokerage firms and investors’ costs go up, it could mean fewer participants and loss of liquidity in the overall markets. For now, retail investors in the United States seem to be benefiting from the current system.