Payment for Order Flow PFOF and FINRA Rule 5310: A Guide for Online Broker-Dealers

The Committee on https://www.xcritical.com/ Financial Services of the United States House of Representatives held a virtual hearing on Feb. 18, 2021, in which PFOF, as practiced by Robinhood, was a major topic of discussion. Margin Accounts.Margin investing increases your level of risk and has the potential to magnify your losses, including loss of more than your initial investment. Please assess your investment objectives, risk tolerance, and financial circumstances to determine whether margin is appropriate for you.

The Good, The Bad & The Ugly of Payment for Order Flow

The ultimate purpose of PFOF is for liquidity, not necessarily to profit off client orders. And while you might not be paying your broker-dealer to execute your deal, it turns out the brokerage firm is getting paid. This process has caused a bit pfof meaning of controversy in recent years, which is why some brokers like Public.com have opted out of the PFOF business model.

Why is Payment For Order Flow controversial?

PFOF is how brokers get paid by market makers for routing client orders to them. In the 2010s, brokers were forced into a race for the lowest fees possible, given the competition. It can come as a fee per trade, a share of the spread, or other financial incentives. The agreed ban of PFOF, a practice where brokers receive payments for forwarding investor orders to trading platforms such as market makers, must be implemented by 30 June 2026 at the latest. In late 2022, the Monetary Authority of Singapore (MAS) announced a complete ban on payment for order flow (PFOF) in Singapore.

Research Spotlight: Payment for Order Flow and Price Improvement

• PFOF is the compensation a broker receives from a market maker in return for directing orders to a particular destination for execution.
• For example, investing $1,000 in a stock with a $100 share price would net 20 cents in PFOF.
• When a brokerage receives a stock market order, they manage the deal through a clearing firm, which routes orders.
• These and other market makers use high-frequency algorithms that scan exchanges to compete fiercely for orders.
• You can also send limit orders (orders that must be filled at a specific price) that are “inside” the quoted best bid and offer.

Apex Clearing Corporation, our clearing firm, has additional insurance coverage in excess of the regular SIPC limits. The broker receives the order and routes it to a market maker, who offers to sell it at $99.00 but first buys it for $98.90 and keeps the $0.10 difference. It might not seem like a lot, but market makers execute many trades a day, so those cents add up.

Beware the Ides of March – practical considerations if your bank is failing

As this area of the industry develops, TRAction remains committed to making trade reporting simple by staying ahead of regulatory developments and monitoring for changes that may affect our clients. EU Parliament is negotiating a draft restriction on PFOF put forward in December 2022 which still leaves individual member states with discretion to allow it. Regulators may look to create an all-out ban for the PFOF model or, more likely, look to create a watered-down version that allows for clearer oversight. Regulating bodies may look to create a system of more open and transparent auctions for order flow, where the data can be monitored and analysed efficiently to stamp out any malpractice in the industry. More broadly, we are seeing talk in regulatory and policy circles about banning PFOF entirely. At the end of August 2021, SEC Chair Gary Gensler openly admitted that a total ban of payment for order flow (PFOF) is “on the table.” Market opinion-makers have rightly signaled this as a significant concern for online broker-dealers.

So while CMS brokers and financial firms in Singapore, the UK, EU, Canada, and Australia may be affected right now, the observed shift towards the prohibition of payment for order flow may include more jurisdictions in the future. Payment For Order Flow is a method of transferring some of the profit from market making to the brokers that route customer orders to the market maker. You are responsible for reading, understanding, and agreeing to the National Law Review’s (NLR’s) and the National Law Forum LLC’s  Terms of Use and Privacy Policy before using the National Law Review website. The National Law Review is a free-to-use, no-log-in database of legal and business articles.

Nevertheless, brokers have a strong incentive to encourage more options trading, especially in a zero-commission trading environment. According to a 2022 study, which is in line with similar reporting and studies, about 65% of the total PFOF received by brokers in the period studied came from options. Just 5% of revenue was from S&P 500 stocks, with the other 30% being non-S&P 500 equities. For example, investing $1,000 in a stock with a $100 share price would net 20 cents in PFOF. But a $1,000 investment in an equity option with a price of $10 would net $4 in payment flow, 20 times the PFOF for a stock. The agency had charged Robinhood with making inadequate disclosures to clients and with receiving a much higher portion of the market maker’s spread in its PFOF deals from 2015 to 2018 than did other brokerage firms.

Changes in the complexity of trades involving equity, options, and cryptocurrency have come about as exchanges and electronic communication networks have proliferated. Market makers are entities, typically large financial firms, that provide liquidity to the financial markets by buying and selling securities. They are ready to trade at publicly quoted bid and ask prices so that someone somewhere has the stock to send you when you enter a trade on your brokerage screen, and they profit from the spread between the buying and selling prices of securities. PFOF is a practice where brokers (typically retail brokers) receive payments from third-party firms for providing them with access to their trades. Essentially, trades are directed to market makers or hedge funds who then execute the trades on behalf of clients.

It avoids conflict of interest by discovering the best available prices and routing your orders to the venue offering the best execution independent of Payment For Order Flow. Investment firms operating in multiple jurisdictions will then only be able to receive payments in connection with transactions of clients domiciled or established in a Member State that have made use of the grandfathering rule. Payment for order flow (PFOF) is the compensation a broker receives for routing trades for trade execution to a particular market maker. SEC defines pfof as a method of transferring some of the trading profits from market making to the brokers routing the orders. When it comes to PFOF, however, digital broker-dealers may be tempted to route trades to the highest bidder rather than to market makers who offer the best price and fastest execution. Such an arrangement could be more profitable for the broker while being detrimental to the end investor.

And even if it’s paying the broker half a cent per share in exchange for routing its orders, it’s still making a great profit. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, personal finance education, top-rated podcasts, and non-profit The Motley Fool Foundation. Despite the rationale and mechanics of PFOF (and the fact that bid-ask spreads—and commission costs—have continued to fall) the practice was cast in a negative light by the media, and alarm bells were raised with regulators. Some—including SEC chair Gary Gensler—floated a potential ban of the practice.

Therefore, I would assume that the most important reason for the ban is to create a level playing field. It is yet uncertain how other Member States will react and whether they will use the grandfathering rule and what the consequences for cross-border-payments will be. It is quite likely that a number of Member States will follow the German example. However, some Member States have already indicated that they will not make use of any grandfathering and apply the prohibition of PFOF immediately. All investing is subject to risk, including the possible loss of the money you invest.

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It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. Market and economic views are subject to change without notice and may be untimely when presented here.