Payment for Order Flow (PFOF): Definition and How It Works

Payment for order flow (PFOF) is a form of compensation, usually in fractions of a penny per share, that a brokerage firm receives for directing orders and executing trades to a particular market maker or exchange.

Many brokers stopped charging investors many of the old trading commissions in the mid-2010s, and payment for order flow (PFOF) is the oft-cited reason. PFOF also could again be the primary driver for why options trading has exploded among retail investors since before the pandemic.

The fractions of a penny given for each share in PFOF may seem small, but it's big business for brokerage firms because those fractions add up, especially if you're making riskier trades, which pay more.

Below, we explain this practice and the effects it can have on novice and experienced investors alike. We provide some examples, show why it's become such a significant issue in recent years, review the regulations meant to protect investors in this area, and discuss the conflicts of interest that could be costing you each time you trade, even if you don't it see as a fee in your account.

Understanding Payment for Order Flow (PFOF)

Grasping how PFOF works enables investors to appreciate how no trade is really free because if they aren't paying for the services involved in trading, then someone else is. In this case, a large part of the cost for trading is taken up by market makers and other "wholesalers" in the PFOF to brokers. As reports from SEC studies have shown, clients, at least in some cases, may be paying more in the end despite discounted or free trading for many.

Indeed, researchers at the London Business School have likened commission-free brokerage trading to exchanging currency at a foreign airport: you get commission-free trades, but they have awful spreads between the currencies that cost far more than elsewhere. It's not an extreme analogy: The researchers found retail investors often chose weekly options with an average bid-ask spread of 12.6%.

Changes in the complexity of trades involving equity, options, and cryptocurrency have come about as exchanges and electronic communication networks have proliferated. Market makers are entities, typically large financial firms, that provide liquidity to the financial markets by buying and selling securities. They are ready to trade at publicly quoted bid and ask prices so that someone somewhere has the stock to send you when you enter a trade on your brokerage screen, and they profit from the spread between the buying and selling prices of securities.

The rise of low- or no-commission trading took off after Robinhood Markets (HOOD), the low-commission online brokerage, began offering such services in 2013. As other brokerages were forced to cut commissions to compete, PFOF became a greater proportion of a brokerage's income. Near-0 % interest rates exacerbated this during the pandemic, though rate hikes have boosted broker revenue from client money parked in their accounts. Still, any moves by the SEC to curtail PFOF would affect millions of investors.

There are major differences in how market makers and other "wholesalers" compensate brokers for executed trades. A 2022 study, in line with others, found that about 65% of PFOF revenue for brokerages came from options trading, with about 30% for non-S&P 500 stock trading and just 5%, or 1 out of every $20 in revenue, coming from S&P 500 stock trading.

The practice is perfectly legal if both parties to a PFOF transaction execute the best possible trade for the client. Legally, this means providing a price no worse than the National Best Bid and Offer (NBBO). Brokers are also required to document their due diligence, ensuring the price in a PFOF transaction is the best available.

The purpose of allowing PFOF transactions is liquidity, ensuring there are plenty of assets on the market to trade, not to profit by giving clients inferior prices. But the practice remains contentious. The EU moved last year to phase out the practice by 2026, and calls for the SEC to do the same have led only to proposals to restrict and provide greater transparency to the process, not ban it altogether.

How Does Payment for Order Flow Work?

PFOF is how brokers get paid by market makers for routing client orders to them. In the 2010s, brokers were forced into a race for the lowest fees possible, given the competition. PFOF allowed the brokerages to make up for lost customer commissions. It can come as a fee per trade, a share of the spread, or other financial incentives.

Investors use brokerage services to buy or sell stocks, options, and other securities, generally expecting good execution quality and low or no commission fees. But they might not know the broker's PFOF arrangements. While investors don't directly participate in the arrangement, how well their trade is executed can be affected by it.

In the PFOF model, the investor starts the process by placing an order through a broker. The broker, in turn, routes this order to a market maker in exchange for compensation. The market maker then executes the order, aiming to profit from the spread or other trading strategies. While this system can benefit investors through lower trading costs, potential conflicts of interest about the quality of trade execution could arise, which is why the SEC and the Financial Industry Regulatory Authority (FINRA) have rules in place to require due diligence by brokers to find trades in the best interest of clients.

Regulators are now scrutinizing PFOF—the SEC is reviewing a new major proposal to revise the practice, and the EU is phasing it out by 2026—as critics point to the conflict of interest that such payments could cause.

Example of Payment for Order Flow

Suppose you're using "XYZ Brokerage" to trade stocks. XYZ Brokerage offers commission-free trades, the main attraction for you to use its services. You want to buy 100 shares of a company called "TechnoCorp" at the market price. Here generally are the steps involved:

1. Placing the order: You put in a buy order for 100 shares of TechnoCorp through XYZ Brokerage's trading platform.
2. Routing the order: Instead of sending the order directly to a stock exchange, XYZ Brokerage routes the orders to a third-party market maker, "Alpha Market Makers," from which it will get a PFOF.
3. Payment for order flow: Alpha Market Makers pays XYZ Brokerage a small fee for each trade it receives. This fee could be a fixed amount per order or a percentage of the spread on each trade. For example, Alpha Market Makers might pay XYZ Brokerage 1 cent per share. So, for your order of 100 shares, XYZ earns $1.
4. Executing the trade: Alpha Market Makers executes your order. It might buy shares of TechnoCorp at $50 each (the ask price) and sell them to you at $50.05 (bid price), earning a spread of 5 cents per share. Thus the total cost for the trade is $5,005.

While you benefit from commission-free trading, you might wonder whether it was the best execution, as XYZ Brokerage has a financial incentive to route orders to Alpha Market Makers. Critics of PFOF argue that this is a conflict of interest because the broker's profit motive might override the duty to provide the best-executed trades for clients.

PFOF for Equities vs. Options

While commission-free brokerages like Robinhood receive a majority of their revenue through PFOF, there are significant differences in the PFOF between trades executed for stocks and options.

For retail investors ordering well-known stocks and other assets, routing orders to market makers for PFOF could be a benefit because market makers bulking up trades in this way can offer tighter bid-ask spreads than traditional exchanges. Meanwhile, retail investors get commission-free trading.

Explosion in Options Trading

Stopping there, though, would be misleading as far as how PFOF affects retail investors. Trading in the options market affects supply and demand for stocks, and options have become far more popular with retail investors. Retail trading in equity options has risen dramatically in the last five years, from just about a third of equity options trading in 2019 to around half of all options of all equity options trades.

A 2022 study found that sending orders to market makers is a bad deal for options traders because of wider bid-ask spreads. This could, of course, have knock-on effects on the supply and demand in equities trading, affecting retail investors not trading options.

But options trading isn't some rarefied strategy used by the few. Most estimates suggest that about half of all equity options trades by volume now come from retail investors, with estimates from the New York Stock Exchange in December 2023 putting it at 45% in July of that year.

Regardless, this is still an astounding change over the same period in which low- or no-commission brokerages came on the scene. Just before the pandemic, about a third of the equity options trading volume was from retail investors. But this explosive growth came on the heels of a major rise in options trading in the 2010s, with more than tenfold as many equity options coming from retail investors in 2020 than in 2010.

Options and PFOF

PFOF is more prevalent and lucrative in options trading than stocks for several reasons:

• Higher spreads in options: Options generally have wider bid-ask spreads than stocks. This is due to the complex nature of options, which includes volatility, time decay, and the underlying stock's price movements. Wider spreads offer more profit potential for market makers, enabling them to pay higher rebates to brokers for order flow.
• Lower volume, higher value trades: Options trading often involves lower volumes but higher-value trades than stocks. The lower volume means less liquidity, and market makers can provide this liquidity at a premium, again justifying higher PFOF.
• Increased complexity and risk management: Market makers specializing in options can manage these risks and are thus willing to pay for the order flow that helps them balance their positions and hedge their exposures.

Market makers thus provide brokers with significantly more in PFOF for routing options trades to them, both overall and on a per-share basis. Based on data from SEC Rule 606 reports, researchers in the 2022 study mentioned above calculated that the typical PFOF paid to a broker for routing options is far more than for stocks.

For example, investing $1,000 in a stock with a $100 share price would net 20 cents in PFOF. But a $1,000 investment in an equity option with a price of $10 would net $4 in payment flow, 20 times the PFOF for a stock. Of course, not all differences in options and stock trades would be so stark. It depends on the number of securities ordered and the type.

Nevertheless, brokers have a strong incentive to encourage more options trading, especially in a zero-commission trading environment. According to a 2022 study, which is in line with similar reporting and studies, about 65% of the total PFOF received by brokers in the period studied came from options. Just 5% of revenue was from S&P 500 stocks, with the other 30% being non-S&P 500 equities.

For instance, regulations already require brokers to search for the best trades for their clients. While some have suggested that the SEC should do more on this front, it's not too difficult for regulators and individual clients to assess because the data for trades executed can be compared with the posted spreads.

However, it's far more complicated to check if a brokerage is funneling customers into options, non-S&P 500 stocks, and other higher-PFOF trades. This would be a much more lucrative conflict of interest. While harder to show (the correlation of massive increases in trades with low- or no-commission brokers and retail options trading isn't causation) this poses a far greater conflict of interest than the one typically discussed.

SEC Requirements and PFOF Regulations

Given this background, it's no surprise that the SEC says that PFOF could "raise concerns about whether a firm is meeting its obligation of best execution to its customer." These concerns could chip away at investor confidence in the financial markets.

The SEC has been looking at the issue for years. The Regulation National Market System (NMS), enacted in 2005, is a set of rules aimed at increasing transparency in the stock market. Most relevant here are the rules designed to ensure that investors receive the best price execution for their orders by requiring brokers to route orders to achieve the best possible price.

An important part of the NMS was creating the NBBO, which requires all trading venues to display their best available bid and offer prices, and for trades to be executed at these prices or better. This was meant to promote competition among trading venues, which should lead to better prices for investors.

SEC Rules 605 and 606

Regulation NMS requires brokers to disclose their policies on PFOF and their financial relationships with market makers to investors. Your brokerage firm should inform you when you first open your account, and then update you annually about what it receives for sending your orders to specific parties.

Brokerage customers can ask for payment data for specific transactions from their brokers, though it could take weeks to get a response. Regulation NMS, through its Rules 605 and 606, also requires broker-dealers to make two reports available, one to disclose the execution quality and the other to give the payment for order-flow statistics. The format and reporting requirements have changed somewhat since.

Rule 606 was updated in the first quarter of 2020. The changes required brokers to disclose the net payments received each month from market makers for equity and options trades. Brokers must also reveal their PFOF per 100 shares by order type (market, marketable-limit, nonmarketable-limit, and other orders).

Further Changes and Rule 615 Proposed in 2022

In December 2022, the SEC proposed updates to Rule 605’s disclosure requirements. The rule would cover more entities, including broker-dealers with 100,000 or more customer accounts. (For now, it applies to “market centers”: exchange and over-the-counter market makers, alternative trading systems, etc.)

Brokers would also need to provide far more information for the trades executed: average, median, and 99th-percentile time to execution, measured in milliseconds; spread statistics after 15 seconds and one minute; nonmarketable orders that became executable; and potentially orders outside regular trading hours and with stop prices.

The standards for what a broker must do for their clients would ratchet up. Brokers-dealers would have to perform reasonable diligence to find the best market for securities and the most favorable terms for their clients.

These proposals are meant to directly answer worries about potential PFOF conflicts of interest.

Potential Benefits of PFOF

The SEC permitted PFOF because it thought the benefits outweighed the pitfalls. Smaller brokerage firms that may have trouble handling large numbers of orders can benefit from routing some of those to market makers. Brokers receiving PFOF compensation may be forced by competition to pass on some of the proceeds to customers through lower costs, like low- or no-commission trading.

The lowering of fees has been a boon to the industry, vastly expanding access to retail traders who now pay less than they would have previously. However, these benefits would disappear any time the PFOF costs customers more through inferior execution than they saved in commissions.

Criticisms of PFOF 

The practice of PFOF has always been controversial for reasons touched upon above. There's also some history here. Bernard Madoff was an early practitioner of payments for order flow, and firms that offered zero-commission trades during the late 1990s routed orders to market makers, some of whom didn't have investors’ best interests in mind. Traders discovered that some of their "free" trades were costing them more because they weren’t getting the best prices for their orders.  

The SEC stepped in and studied the issue in-depth, focusing on options trades. It found that the proliferation of options exchanges and the additional competition for order execution narrowed the spreads. Allowing PFOF to continue, the SEC argued at the time, fosters competition and limits the market power of exchanges.

PFOF became the subject of renewed debate after a 2021 SEC report on retail investor mania for GameStop (GME) and other meme stocks. The SEC said it believed some brokerages might have been encouraging customers to trade so they could profit from PFOF.

The SEC had reason to worry before the meme stock mania. The previous year, the SEC fined Robinhood $65 million for failing in late 2010 to properly disclose to customers the PFOF it received for trading and for failing to execute the best trades for their clients.

The Bottom Line

Brokers’ commissions have changed with the rise of low-cost alternatives and online platforms. To compete, many offer no-commission equity (stock and exchange-traded fund) orders. As a result, PFOF has become a more significant source of revenue.

A common contention about PFOF is that a brokerage might be routing orders to a particular market maker for its own benefit, not the investor’s. Investors who trade infrequently or in very small quantities might not feel the direct effects of their brokers’ PFOF practices, although it might have wider effects on the supply and demand in the stock market as a whole. Frequent traders and those who trade larger quantities at one time need to learn more about their brokers’ order-routing process to ensure they’re not losing out on price improvement.