The term payment for order flow (PFOF) denotes a business practice used in the trading of stocks and some other assets. In this practice, stock brokers and trading platforms are paid to pass on customer orders to specialized trading firms.
In the PFOF model, orders to buy or sell shares in stocks are sent to one or more trading firms (typically market makers) which act as the counterparty for the trade. This sets PFOF trading apart from the conventional stock trading model, in which orders are sent to a stock exchange and matched with the best available offer or bid.
When a trade is executed using the PFOF model, the stock is bought or sold at the price which the market maker offers. The price you pay for a share will generally include a markup on the price which the market maker paid for it. The price you get for a share will generally include a markdown on the price for which the market maker will resell it. This spread makes up the market maker’s profit.
The PFOF model is most widely used by free online trading platforms. Instead of charging the customer a brokerage fee to execute a trade, the trading platform receives a sales commission for passing on their trade to a market maker. This sales commission — also known as payment for order flow — is generally a portion of the profit which the market maker earns from the markups it adds to stock prices.
PFOF practices are not limited to free trading platforms, as stock brokers may use the PFOF model to earn commissions from certain trades even though they also charge brokerage fees.
Example of payment for order flow vs. conventional stock trading
Conventional stock trading: You place a market order to buy 100 shares in a Swiss company with a stock broker. The stock broker sends your order to the SIX Swiss Exchange. The best available bid is from a seller who is willing to sell that stock for 15 francs per share. The broker buys the shares for 15 francs a piece, or a total of 1500 francs. In exchange for its service, the stock broker charges you a 5-franc brokerage fee. The cost of the trade for you is 5 francs.
Payment for order flow stock trading: You place the same order for 100 shares in the same Swiss company, but with a free trading platform which uses the PFOF model. The stock broker sends your order to a market maker which deals in that stock. The market maker charges 15.05 francs per share, or a total of 1505 francs. The market maker earns 0.05 francs per share over the best available offer (15 francs on the stock exchange). In this case, the cost of the trade for you is 5 francs — the same amount you would have paid for trading on the exchange in the example above.
Which model works out cheaper depends on the sizes of market maker spreads and on the brokerage fees charged for trading on stock exchanges.
Potential for conflicts of interest
Stock brokers and other trading platforms which use payment for order flow business models receive sales commissions from market makers. Some market makers offer higher sales commissions than others. This creates potential for conflicts of interest. A trading platform may choose to work with a market maker which has bigger markups and markdowns on stock prices if that market maker offers higher sales commissions.
Another potential problem which can arise when investors are limited to trading with just one counterparty is that the market maker may choose to halt trading in a security which becomes very volatile. This may leave you unable to buy or sell certain securities.
Because of potential conflicts of interest, among other factors, the use of PFOF models remains the topic of ongoing legislative discussions (in the European Union, for example).
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