March 21, 2023
Is Free Trading Really Free: Understanding Payment For Order Flow
Commission-free trading was popularized during the pandemic and millions of retail traders opened accounts on free-trade platforms such as TD Ameritrade and Robinhood in the US. In Canada, some operators such as National Bank and Wealthsimple have also followed suit with free-trade offerings. How then, do the free-trade platform operators make their money? Mostly from payment for order flow (PFOF).
Payment for order flow is the compensation received in exchange for routing client trade orders to a market maker. The market maker, in turn, makes their profits from the bid-ask spread on these orders when executing the trades.
We will use a simple example to illustrate how PFOF operates. Suppose a market maker purchases Apple (AAPL:US) for $150.00 from a seller, and then immediately sells the stock for $150.04 to a buyer. The market market would make $0.04 profit. If this can be done on millions of orders per day, the profits quickly add up. The market maker is therefore willing to share some of these profits with the free-trade platform operators to receive their order flow, especially since these free-trade platforms have attracted millions of new traders who trade (for free) using market orders.
The rationale behind PFOF is that it allows brokers to offer low (or no) commission fees, thereby making trading more accessible to retail investors who trade smaller volumes of highly liquid stocks. Historically, retail investors were paying commissions in excess of $40 per trade, which made it unprofitable to make trades with small sums of under $500, for example. PFOF has changed all of that, and now retail traders can even trade fractional shares of their favourite company.
Market makers are licensed and regulated and play an essential role in the stock market by providing liquidity, setting bid-ask spreads, facilitating the exchange of securities, and managing order flow.
Retail investors can use marketable orders for immediate trades at the best current available price. In the US, retail brokers route more than 90% of retail investor orders to a small group of off-exchange dealers known as wholesalers which has caused the markets to become increasingly hidden from view for individual investors. In December 2022, the SEC proposed a rule to enhance competition for individual investor order execution to address this estimated $1.5 billion annual concern.
Critics of PFOF view the practice as a kickback scheme designed to enrich market makers and platform operators at the expense of the retail investors. They point to the behavioral risk of stock market gamification which encourages retail investors to trade frequently by adding game-like features in the trading apps to make the experience more exciting, like playing a video game. More frequent trades means more PFOF revenues - from retail investors.
The inherent PFOF conflict of facilitating the best execution price for customers has already been met with steep regulatory fines in the US when the SEC fined Robinhood for providing “inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.” Regulators in Canada, Australia and the UK have banned PFOF on trades of companies listed in their jurisdictions due to its conflicts. However, the EU recently rejected plans for an outright ban on PFOF.
Commission-free trading has allowed millions of new traders and investors to open accounts and participate in the stock market for the first time. PFOF has been the enabling factor, but the debate concerning the inherent conflicts of PFOF is ongoing. Proponents argue that it benefits small investors and improves market liquidity, while opponents argue that it leads to conflicts of interest and lower overall returns for investors.
Regulators are watching carefully, and the new rules currently proposed by the SEC are likely to help shrink the opinion gap that PFOF has caused over the retail investor’s new role in the stock market.
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