Broker-Dealers and Payment for Order Flow
April 2, 2021
Broker-Dealers and Payment for Order Flow
Introduction
Alphacution also reported that stock options—which have
The last few years have witnessed an unprecedented surge
been described as an “accelerant” in the speculative trading
in retail investor securities trading at major discount broker-
of “meme” stocks such as GameStop, AMC, Blackberry,
dealers such as Robinhood, Charles Schwab, TD
and Bed Bath and Beyond—accounted for 61% of total
Ameritrade, and E*Trade. Among the factors that have
PFOF in 2020.
driven this are the zero trading commissions that many of
them now charge for trades. The non-existent commissions
Market Makers
are often subsidized by a controversial rebate to the broker-
Broker-dealers receive small payments, typically in
dealers called payment for order flow (PFOF).
fractions of a penny per share, as their compensation for
routing orders to market makers. For major broker-dealers,
Market makers, alternatively known as wholesalers, make
those pennies substantially add up. For example, total PFOF
cash payments to retail broker-dealer firms in exchange for
revenue for the first half of 2020 were as follows: $271.2
marketable retail customer stock order flows. In return for
million for Robinhood, $120.1 million for Charles Schwab,
this PFOF, market makers such as Citadel, Virtu,
$189.98 million for E*Trade, and $526.59 million for
Susquehanna, Wolverine, and Morgan Stanley typically
Ameritrade.
execute the orders in-house, called internalization. Market
makers also pay broker-dealers significant amounts of
So why are market makers willing to spend such sums for
PFOF for order flow from stock options—contracts that
stock order flow? According to Georgetown University
give an investor the right, but not the obligation, to buy or
finance professor James Angel:
sell a stock at an agreed-upon price and date. Such trades
are generally not internalized but are instead routed to
[M]arket makers offer to buy from customers at
options exchanges such as the CBOE Options Exchange.
their bid price and sell to them at a slightly higher
offer or ask price. Competition from market makers
Figure 1. Aggregate PFOF Revenue from Four Major
and other investors keeps the “bid-ask spread”
Brokerages
between the bid and ask prices quite small. The
market makers are selling the service of
convenience for investors who want to trade
quickly. They are not long-term investors, nor
should they be. Market makers particularly like to
take the other side of small retail trades because
they know that those retail traders are not
sophisticated institutional investors such as hedge
funds. Market makers know that they can lose when
they trade with large institutions that know more
than they do. Market makers can buy from a retail
order at the bid and sell at the ask or offer and
pocket the bid-ask spread. They don’t need to worry
that retail investors as a group have better
Source: CRS, with data from Alphacution.
information and will dump shares on the market
Notes: PFOF = Payment for order flow.
maker just before bad news is announced.
Competition among market makers for retail order
Reporting from Alphacution, a research firm, indicates that
flow is so intense that market makers are willing to
aggregate PFOF revenue nearly tripled at four major
pay for order flow and offer various levels of “price
broker-dealers—TD Ameritrade, Robinhood, E*Trade, and
improvement”—prices better than the national best
Charles Schwab—to $2.5 billion in 2020 from $892 million
bid and offer (NBBO) prices [the best prevailing
in 2019. By various accounts, PFOF has played a
significant role in helping to lower retail broker-dealer
offers to sell and buy a given stock across various
commissions and then helping to usher in the more recent
trading venues].
era of Robinhood-pioneered zero trading commissions. And
because of this, it has indirectly helped generate a surge in
Best Execution
retail securities investing, which, according to the
For decades, PFOF has been the subject of policy debates
investment bank Piper Sandler, grew from 13% of total
on its merits and shortcomings by regulators, industry
trading share volume in December 2019 to 23% in
stakeholders, academics, and Members of Congress. The
December 2020.
uproar in the winter of 2021 surrounding the behavior of
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Broker-Dealers and Payment for Order Flow
GameStop stock, which was traded by various broker-
“not held” basis that gives the broker-dealer both time and
dealers who received PFOF, has renewed such debates. At
price discretion during the prior six months.
the center of policy debates over the arrangements is the
broker-dealer’s duty of best execution with respect to the
Rule 607. Under Rule 607 of Regulation NMS, broker-
execution of customer trades, a duty that is chiefly enforced
dealers must, upon opening a new customer’s account,
by the frontline regulator of broker-dealers, the Financial
provide annual descriptions of the terms of any payments
Industry Regulatory Authority (FINRA), regulated by the
received for order flow and any profit-sharing arrangements
Securities and Exchange Commission (SEC). Best
that may influence a broker-dealer’s order routing decision.
execution denotes the broker-dealer’s obligation to seek the
most favorable terms for a customer’s transaction in the
The 2020 SEC Robinhood Settlement
context of the prevailing circumstances. Compliance
Providing some ammunition to PFOF detractors, in
parameters are dictated by a mix of FINRA-based rules,
December 2020, Robinhood agreed to pay $65 million to
notably Rule 5310, federal securities statutes, and court
settle charges from the SEC that between 2015 and 2018, it
rulings.
had misled clients on its PFOF revenue and the quality of
its service, which the agency said had cost its customers
Among the factors that may be considered in the fulfillment
$34 million. Robinhood’s chief counsel said that the
of the obligation are the terms of the execution price, the
practices do not reflect the current company.
speed of execution, available execution order sizes , the
security’s trading characteristics, the likelihood of price
The Biden Nominee for SEC Chair
improvement, and the presence of PFOF.
During a March 2, 2021, Senate Banking, Housing, and
Urban Affairs Committee hearing, Gary Gensler, President
The Debate over Conflicts of Interest
Biden’s nominee for SEC chair, said that the agency would
At the heart of the ongoing policy debate over PFOF are
examine “how to ensure that customers still get best
long-term concerns that the arrangement may compromise
execution in the face of payment for order flow.”
the broker-dealer’s duty of best execution. Advocates of
PFOF argue that the arrangement indirectly benefits
Academic Research
investors by subsidizing low or zero commission rates and
Some related academic research has recently been
other services. In addition, they note that marketable retail
conducted. For example, in 2021 research, Adams and
orders that tend to be routed to the PFOF rebaters must be
Kasten found that the adoption of PFOF-facilitated zero
executed under best execution protocols and are done at the
commissions led to improved trade execution quality. And
NBBO or at a price that improves on it. By contrast, critics ,
2020 research by Jain, Mishra, O'Donoghue, and Zhao
including some former SEC officials, say that because
found that PFOF-facilitated zero commissions led to overal
broker-dealers do not generally pass the PFOF rebates onto
improvements in market quality. By contrast, according to a
their clients, they may have economic incentives to send
2016 study by the CFA Institute, a group that certifies
retail orders to rebating market makers, creating potential
investment managers, trades executed at the best-quoted
conflicts over their duty of best execution. PFOF has been
prices surged after the United Kingdom effectively banned
effectively banned in the United Kingdom due to conflict-
PFOF.
of-interest concerns.
Some Policy Options
Prior to the widespread advent of zero commissions, a 2018
A number of policy changes concerning PFOF have been
book, the New Stock Market, by Glosten and Rauterberg
suggested by observers, including:
from Columbia University Press, argued that “the key
question, thus, is whether brokers pass on to customers the
Banning PFOF, which could entail a significant rise in
substantial payments they receive for order flow in the form
broker-dealer commissions;
of lower commissions, given that internalizers offer only
nominal price improvement. Still, if there is a problem,
Enabling investors to opt out of PFOF while
passing through the payments would solve it.”
maintaining market access; and
The Regulation of PFOF
Requiring broker-dealers to produce execution quality
The SEC’s regulatory approach to PFOF basically involves
statistics for their clients .
disclosing its existence.
Related CRS Products
Rule 606. Under Rule 606(a) of Regulation National
CRS In Focus IF11663, Robinhood, the Fintech Discount
Market System (Regulation NMS), adopted by the SEC
Brok er: Recent Developments and Concerns, by Gary
under the Securities Exchange Act, broker-dealers must
Shorter.
provide quarterly, aggregated public disclosure of their
practices in the routing and handling of “held orders”
CRS Insight IN11591, GameStop-Related Market
requiring prompt execution at the best possible price.
Volatility: Policy Issues, by Eva Su.
Generally upon a customer’s request, under Rule 606(b) of
Regulation NMS, a broker-dealer must provide customer-
Gary Shorter, Specialist in Financial Economics
specific disclosures related to the routing and execution of
the customer’s exchange-listed securities submitted on a
IF11800
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Broker-Dealers and Payment for Order Flow
Disclaimer
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