Payment for order flow is a common practice in the investing world that lets retail brokers be paid by market makers, wholesalers and others in exchange their retail clients’ orders to buy and sell securities. Although it’s been criticized as a conflict of interest for brokers to be paid in this way, the longstanding system allows brokers to advertise low- or zero-commission trades to retail customers. A financial advisor can help you find various ways to make your portfolio as economical as possible.
Payment for order flow is of particular importance for small broker-dealers who may not be able to invest in the systems and technology to efficiently execute thousands of trades per day for their clients. By sending their trades to large wholesalers to execute, they can offer faster service and provide additional revenues to offset the effects of charging lower commissions. The economies of scale built by large wholesalers are made available to smaller firms and their clients, along with faster execution thanks to heavily automated electronic systems.
The Securities and Exchange Commission requires that brokers disclose whether they are paying for order flow. However, few investors check the disclosures and even fewer request the details to find out who is being paid and how much.
Financial Impacts of Paying for Order Flow
Many retail clients are not aware that their brokers are getting paid to route their trades to specific market makers and other entities. For most, it’s not a major consideration. The amounts of money brokers are paid per transaction for directing order flow are small. Typical payments for order flow may be a few tenths of a penny per share. These amounts are not important for long-term investors who practice buy-and-hold strategies. However, for active traders who have many transactions the amounts can add up and may be of concern.
In addition to added costs, retail investors could potentially also be disadvantaged if a market maker does not execute the requested trade in the most efficient manner. This could happen if, for instance, a broker selects a wholesaler because it pays more rather than because it executes trades swiftly and efficiently and at a price that is most advantageous to the retail customer.
Regulators have studied payment for order flow and opted to allow it to continue with some restrictions and requirements for disclosure. And retail investors do benefit significantly by paying low or no commissions and, especially if they are clients of small brokerages, by getting better and faster executions on their trades.
In 2018 the Securities and Exchange Commission amended its Rule 606 with changes aimed at pay for order flow. It requires broker-dealers to produce quarterly reports disclosing close pay for order flow deals to their clients. In addition to these disclosures that provide an overview of their pay for order flow arrangements, brokers are required to tell clients who request it the identity of the entity that is paying them for order flow as well as the amounts they are being paid.
How Payment for Order Flow Works
The entities that pay brokers for routing orders do so because they can make more money by having larger volumes of orders. They generate revenues from order flow using several different means, including buying shares on the low end of bid-ask spreads and then selling the shares to an investor who has placed an order for shares at the higher end of the bid-ask spread. They may also trade against the investor’s order by selling shares short and driving the price down, allowing them to fill a retail investor’s order for shares at a certain price with shares purchased for less, generating a profit on the difference.
A number of different types of firms may pay brokers for order flow. Wholesalers, for instance, are highly automated broker operations that emphasize extremely speedy execution times and wring profits as small as one ten thousandth of a cent per share on transactions. With such small spreads, they require very large order volumes to produce sufficient profits and so are willing to pay brokers to send them more orders.
Market makers also pay for order flow. These are brokers who typically specialize in certain securities, carrying shares and options on those issues in inventory to they can fill orders from their holdings very quickly. They also benefit from high order volume. Other entities that pay for orders include traditional exchanges and electronic communication networks.
Payment for order flow has become a major contributor of revenue supporting retail investment brokers. The practice allows brokers to be paid for sending their clients orders to buy and sell securities to specific entities. This helps make up for declining commissions and allows for low- and zero-commission investing.
Tips for Investing
- If you are a retail customer of a discount brokerage or zero-commission fintech investing platform and wonder how payment for order flow affects your investment returns, consider working with an experienced financial advisor. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Make sure your investments fit your risk profile. SmartAsset’s free, easy-to-use asset allocation calculator will help you align your assets with your risk tolerance.
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