Payment For Order Flow & The Fleecing Of The Retail Investor

Payment for order flow (PFOF) is not new. Previously, in a less connected world of instantaneous data flows, PFOF was minimal and non-invasive. Today, with high-frequency trading, dark pools, and algorithms running amok, retail traders are fodder for Wall Street profits.

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Some Background

In financial markets, PFOF refers to compensation a broker receives third parties to influence how the broker routes client orders for fulfillment.

Read that again.

For many years, paying for order flows allowed firms to centralize customers’ orders for another firm to execute. Such allowed smaller firms to use economies of scale of larger firms. By allowing small firms to combine orders with larger firms, it provided better execution quality.

Over the years, the decimalization of the trading securities diminished the profitability of trade execution. Such pushed Wall Street toward PFOF as a way to generate revenue and subsidize the move to zero-commissions.

The advances in technology and data analysis increased the speed with which information gets sent and received. Over the last decade, Wall Street spent billions to figure out ways to take advantage of the data and “game the system.”

Today, Robinhood, and others, generate the bulk of their revenues from selling order flows to the highest bidder. 

Free Isn’t Necessarily “Free”

Think about this carefully. If a firm is selling order flow to the highest bidder, even though you are paying “zero commissions,” you are not necessarily getting the best execution.

In other words, “free” isn’t necessarily “free.”

Such was a point Doug Kass made recently:

“In 2004, Citadel made the argument to the SEC the practice of selling order flow should be illegal.”

payment order flow retail, Payment For Order Flow & The Fleecing Of The Retail Investor

During the 90s, several firms offering “zero-commission trades” routed orders to market makers failing to execute in investors’ best interests.

Such was during the waning days of fractional pricing, and for most stocks, the smallest spread was ⅛ of a dollar, or $0.125. Spreads for options orders were considerably wider. Traders discovered their “free” trades cost them quite a bit since they didn’t get the best transaction price.  

At that point, the SEC did step in to conduct a study. The result was a near ban on PFOF. The study found, among other things, the proliferation of options exchanges narrowed spreads due to the additional competition for order execution.

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