What is a payment for order flow (PFOF)?
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PFOF is when brokers get paid to send customer trades to certain market makers rather than directly to the stock exchange, but it’s controversial because it could impact the quality of execution for the trades.
When you buy or sell stocks you are almost never transacting with another person but instead a type of bank known as a market maker. Market makers do just that, they guarantee a market by always being willing to buy or sell a security. They don’t make money on the actual security going up or down in value but rather through the bid ask spread. So if stock ABC has a bid of $10 and an ask of $11 this means the MM will sell a stock to you for $11 and buy for $10, collecting the $1 difference. For any liquid security this spread is going to be closer to a penny.
Now when you tell your brokerage to buy or sell a stock they are obligated to get you the best price available. So if you put in a buy order for stock ABC and there are multiple sellers your brokerage has to go with the best price. If there are multiple sellers with the same price and that is the best price available then your broker can route the order to a specific MM in exchange for a kickback. This is basically what payment for order flow is.
PFOF is also a large part of why there are $0 trading fees today. Not even 10 years ago $5 per trade was seen as a cheap price.
If you are a company which offers to buy and sell any stock then you are a market maker. Market makers who offer to trade with anyone will often end up trading with very large very clever people called hedge funds.
For a market maker to be profitable when trading against these ultra smart guys they have to set a big difference between the price they buy and sell at.
If you could only take orders from regular non-smart people then you could set the difference between buy and sell prices much lower and make even more profit than before. You can take a portion of this extra profit and feed it back to the person sending you these orders as a thank you for bringing in this profitable business. That’s PFOF.
PFOF money allows brokers to offer their service for free. Your orders are the product, the market makers are the customers.
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