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February 20, 2024
Payment for Order Flow (PFOF) and Broker-Dealer Regulation
Policymakers have scrutinized certain rebates that
handled more than 80% of U.S. retail equity market orders
brokerage firms receive for executing retail investor stock
at one time.
trades, with particular attention to payment for order flow
(PFOF). PFOF raises issues related to potential conflicts of
Zero-Commission Trading
interest, retail investor financial inclusion, market
Over the past four decades, retail investor trading
competition, and market transparency. This In Focus
commission fees reportedly went from about $200 per trade
explains PFOF, the broker-dealer regulatory framework
in the 1980s to $40 in the 1990s (when PFOF first started),
governing it, related policy debates, and legislative actions.
and eventually reached zero in the 2010s (though there are
debates about hidden costs, discussed later). Major discount
What Is PFOF?
brokerages such as Charles Schwab, E*Trade, Robinhood,
PFOF is fee income received by a brokerage firm in the
and TD Ameritrade (which merged with Charles Schwab in
form of rebates for routing buy or sell orders from retail
October 2020) manage a significant amount of retail trades.
stock investors to a wholesaler (also called market maker),
By various accounts, PFOF has played a significant role in
who takes the other side of the order (Figure 1). The
enabling zero-commission trading, as the discount
wholesalers typically execute the orders in house in an
brokerages could still make a profit from PFOF revenue,
internalization process, which fills the orders with the
which has helped drive the recent surge in retail trading
firm’s own inventory of stocks. The internalization allows
since the COVID-19 pandemic.
wholesalers to make money through spreads, the difference
between purchase price and sale price. PFOF was pioneered
Broker-Dealer Regulatory Framework
in the 1990s by Bernard Madoff, who at the time had a
Because retail investor PFOF is generally executed through
stellar reputation but was later convicted of financial
broker-dealers, a broad array of Securities and Exchange
crimes. Although there were no indications that Madoff’s
Commission (SEC) and Financial Industry Regulatory
use of PFOF was illegal or unethical, the practice’s origin
Authority (FINRA) rules and regulations governing broker-
may have somewhat tarnished PFOF’s reputation.
dealers generally apply to transactions involving PFOF. The
main requirements to highlight include best execution and
Figure 1. Payment for Order Flow Process
information disclosure.
Best Execution
The duty of best execution requires a broker-dealer to
execute customers’ stock trades at the most favorable terms
under prevailing market conditions. The brokerages must
evaluate the orders from all customers and periodically
determine which competing markets and market
intermediaries offer the most favorable terms for execution.
The brokerages must consider price improvements, which is
the opportunity (but not the guarantee) for an order to be
Source: SEC.
executed at a better price than the current quote. Because
Notes: In executing customer orders, the broker has to fulfil “Best
transaction timing is also a key consideration, the
Execution” obligations.
brokerages must also consider the trade-off between price
improvements and the extra time it takes to seek better
While PFOF is generally a fraction of a cent per trade,
pricing. The SEC has no existing rules on best execution,
cumulatively, it can result in significant earnings for
but FINRA has a best execution rule (Rule 5310), which
brokerage firms due to high transaction volume. For
was first established in 1968 by its predecessor, the
example, the 12 largest U.S. brokerages earned a total of
National Association of Securities Dealers. In addition,
$3.8 billion in PFOF revenue in 2021. Robinhood, an online
broker-dealers have a best execution duty derived from
investment platform, alone collected $974 million,
certain legal principles and fiduciary obligations, which are
representing approximately half of its revenue. In the
enforced through antifraud provisions of securities
previous year, about 75% of Robinhood’s revenue came
regulation.
from PFOF. In aggregate, brokerages routed more than 90%
of marketable orders of retail national market system stocks
Disclosure and Transparency
to a concentrated group of six wholesalers in 2022. The top
Under SEC Rule 606(a) of Regulation National Market
three wholesalers—Citadel Securities (41%), Virtu
System (NMS), broker-dealers must provide quarterly,
Financial (26%), and G1 Execution Services (16%)—
aggregated public disclosure of their practices in the routing
and handling of “held orders” requiring prompt execution at
https://crsreports.congress.gov
Payment for Order Flow (PFOF) and Broker-Dealer Regulation
the best possible price. Under Rule 606(b) of Regulation
contrast, another study found that retail trades executed at
NMS, upon a customer’s request, a broker-dealer must
the best-quoted prices surged after the United Kingdom
generally provide customer-specific disclosures related to
effectively banned PFOF. Other research found that PFOF-
the routing and execution of the customer’s exchange-listed
facilitated zero commissions led to overall improvements in
securities submitted on a “not held” basis that gives the
market quality, but retail investors received less price
broker-dealer both time and price discretion during the prior
improvement per share. A 2022 study of 85,000
six months. Under Rule 607 of Regulation NMS, a broker-
simultaneous market orders with five brokers concluded
dealer must, upon opening a new customer’s account,
that PFOF does not appear to harm price execution. The
provide annual descriptions of the terms of any payments
SEC’s analysis as part of a rulemaking process (discussed
received for order flow and any profit-sharing arrangements
below) indicates that replacing the current PFOF model
that may influence a broker-dealer’s order routing decision.
with a new order-competition model could generate $1.5
billion in annual savings for retail investors, but multiple
Policy Debates
commentators challenged the SEC’s estimates. That said,
PFOF’s opponents are concerned about the practice’s
even under the larger estimates of potential hidden costs,
potential adverse effects on market competition and trading
the decline in overall retail investor trading costs under
order execution quality for retail investors. Proponents
zero-commission trading is evident. As discussed
argue that PFOF does not negatively affect price execution
previously, commission costs went from $40 in the 1990s to
and that eliminating it could reduce retail investor
$0 now, and hidden costs from a potential reduction of
participation and introduce new risks and uncertainties in
execution quality are generally not believed to be of that
trade execution.
magnitude. For example, in December 2020 the SEC
charged Robinhood with failure to disclose its receipt of
Market concentration and competition. As previously
PFOF for routing customer orders and noncompliance with
discussed, the market for retail order routing is highly
the duty of best execution. An analysis cited in the SEC
concentrated among several large wholesalers. Some
order indicates that for orders of more than 100 shares, the
commentators worry that the market is opaque and not as
execution loss was $5 per order. The execution loss
fair and competitive as it could be for retail investors.
increased to $15 for orders exceeding 500 shares. Although
Zero-commission trading and retail investor inclusion.
not a perfect example about the hidden costs of PFOF—
Zero-commission trading significantly increased retail
especially given Robinhood’s alleged failure to satisfy the
investor participation in stock trading. Supporters of PFOF
duty of best execution—the $5 to $15 per-order estimated
argue that the practice benefits investors by subsidizing
costs to investors provide some sense of the estimated costs
low- or zero-commission rates and other services, allowing
of PFOF charged by Robinhood at one time. (Robinhood’s
more people to invest their savings in stocks.
chief counsel stated that the firm’s historical practices do
not reflect its current operations.)
Investor protection offered through best execution
requirements. Some commentators argue that with existing
SEC Market Structure Reform Proposals
best execution requirements, brokerage firms have to seek
On December 14, 2022, the SEC proposed multiple rules
the best execution terms for orders irrespective of PFOF.
and amendments to reform the equity market structure. This
Thus, they assert that concerns over best execution are not
initiative includes proposals that would require certain retail
warranted provided that existing best execution
orders to be put up for auction at securities exchanges or
requirements guard the transactions from conflicts of
other trading venues before they could be executed
interest and mandate transaction due diligence. In addition,
internally by any trading venues that restrict order-by-order
they emphasize that marketable retail orders that involve
competition. If implemented, the rule may reduce the
PFOF must be executed at the national best bid or offer
attractiveness of PFOF to wholesalers. The SEC also
price or at a price that improves it. However, others are
proposed a new rule on Regulation Best Execution for the
concerned that broker-dealers may not pass PFOF rebates to
first time. (Recall that FINRA already has a best execution
their clients and that they may have incentives to send retail
rule.) The rule aims to strengthen broker-dealer best
orders to rebating market makers that are the most
execution practices, including those governing PFOF. For
beneficial to them instead of the clients. This creates
more details, see CRS In Focus IF12336, SEC-Proposed
potential conflicts over their duty of best execution. PFOF
Regulations to Reform Stock Trading.
has been banned in the United Kingdom, Australia, and
Canada due to such conflict-of-interest concerns. Also, the
Legislative Proposals
European Union has reached a provisional agreement to ban
The SEC may (under its existing authorities to regulate
PFOF.
aspects of securities trading) change PFOF-related
regulation without a specific congressional mandate. The
PFOF and price execution quality. Policymakers have
Investor Freedom Act of 2021 (S. 3102, 117th Congress)
debated (1) whether PFOF creates a hidden cost for retail
would have prevented the SEC from doing so by amending
investors by leading to the execution of trades at a worse
the Securities Exchange Act of 1934 to explicitly prohibit
price (i.e., a higher price when buying and a lower price
the SEC and certain other organizations from restricting
when selling) for them, and (2) if so, how large it is.
PFOF. Other proposals, such as H.R. 4617 (117th
Academic and other research has not formed a consensus
Congress), would have required the SEC to conduct a study
regarding whether PFOF would improve or harm price
on PFOF from the perspectives of conflicts of interest, price
execution. One study has found that the shift to PFOF-
execution, disclosure, and other investor protection
facilitated zero commissions was beneficial to retail
measures. The bill would have also directed the SEC to
investors in terms of their overall costs of trading. In
https://crsreports.congress.gov
Payment for Order Flow (PFOF) and Broker-Dealer Regulation
implement rules consistent with the results of the study,
Eva Su, Specialist in Financial Economics
including potentially prohibiting or limiting PFOF.
IF12594
Disclaimer
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https://crsreports.congress.gov | IF12594 · VERSION 1 · NEW