Under current Canadian financial laws, payment for order flow is not allowed, forcing most Canadian brokerages to charge trading commissions and currency exchange fees.
What is Payment for Order Flow?
Payment for order flow (PFOF) is a practice where a stockbroker receives compensation from a market maker or liquidity provider for directing its clients’ trade transactions to that market maker.
A market maker is a broker (could be an individual or a firm) that quotes both sell and buy positions for a tradable asset to turn a profit off the bid-ask spread.
By being able to act on both sides of a transaction as the buyer and the seller, market makers can make profits through narrow spreads.
How does Payment for Order Flow Work?
As the SEC defines it, payment for order flow is “a method of transferring some of the trading profits from the market makers to the brokers that route customer orders to specialists for execution.”
With better trading technology and the increasing accessibility to the stock market by retail investors, trading has become increasingly complex.
There are thousands of stocks spanning multiple exchanges, which adds to the difficulty of executing orders.
For this reason, the number of market makers has grown in the US.
Instead of being compensated directly from their clients, brokers mass sell shares to market makers for the execution of the order.
The brokers are compensated in exchange for the stock traffic directed to the market makers.
With PFOF offering a revenue stream to these brokerages, many can provide 0% trading fees for their clients.
The practice has been called into question since many customers are unaware that their brokerages were directing their orders towards specific market makers that may not be getting the best price at the time the transaction was placed.
Did You Know?
Payment for order flow was a large part of the GameStop saga. There were rumours at the time that Citadel Securities, which handled Robinhood’s PFOF orders and accounted for 40 percent of Robinhood’s revenues, played a part in the brokerage firm shutting down trading.
Benefits and Drawbacks
Zero Commission Trading
PFOF allows brokerage platforms to charge zero-commissions to their clients.
This is appealing and can convince more potential clients to sign up use the service since they can trade free of charge.
All Parties Win
Market makers claim they can outperform the national best bid and offer so everyone gets what they want and no one is taken advantage of.
No Regulation of the Profit Split
Market makers can decide how much profit they, the brokers, and the clients receive.
This can be skewed in favour of one more than the others without oversight.
Conflict of Interest
Payment for order flow conflicts with the brokers’ duty of completing the best execution in their clients’ interests.
The market makers can skim higher profits if the buy and sell spread are more significant, which leaves no incentive to follow best execution practices.
Brokers that Receive Payment for Order Flow
Popular brokers that receive payment for order flow include:
- Ally Financial
- TD Ameritrade
- Charles Schwab
Which Countries Allow Payment for Order Flow?
United States of America
At the end of 2021, SEC Chair Gary Gensler put banning Payment for Order Flow on the table.
Despite this, no move has been made to ban the practice, and it continues to be legal in the US.
According to the current SEC regulations, brokers are required to disclose their policies with PFOF and publicize any business relations they have with market makers.
Brokers are also required to notify clients if they were compensated for directing their orders to market makers for execution.
European legislators have regulations to limit Payment for Order Flow, but this practice does exist in Europe.
Even though market makers are not allowed to directly compensate the brokers, workarounds within the laws still allow forms of compensation.
Brokers and market makers can execute the order together and have a more favourable outcome for the market maker.
In return, the broker gets compensated by the market maker, and the retail trading service can offer commission free trading to its clients.
Payment for Order Flow Policy Changes
In early 2020, Rule 606 was changed to require brokers to report all net payments received monthly from market makers for any trades made in S&P 500, option trades, and non-S&P 500 equity trades.
They are also required to disclose the Payment for Order Flow rate per 100 shares by order type.
Frequently Asked Questions
- Why would a company pay for order flow?
If a company has sufficient order flow coming through its systems to be executed, it can capitalize on the bid-ask spread. It can then execute the order at the largest gap in the spread and capitalize on the difference. It doesn’t seem like much with a few hundred orders, but with millions of orders coming in daily, it can quickly become a lucrative business.
- Is paying for order flow legal?
Depending on the country, a broker may or may not be allowed to use this practice. It is still accepted in the US and European Union but it is banned in Canada, the United Kingdom, and Australia due to conflict of interest.