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What is payment for order flow?

The secret behind how “zero-commission” brokers make money.

If you’ve ever considered working with an online broker, you’ve probably encountered the term “zero-commission trading.” Payment for order flow, or PFOF, is one way brokers and third-party traders continue to turn a profit — even as they offer zero-commission trading. Here’s how it works.

What is payment for order flow (PFOF)?

Payment for order flow is the payment brokers receive for directing client orders to third-party traders, also known as market makers. These market makers compensate brokerage firms for client orders by paying a small commission.

Market makers pay brokers for trades because they turn a profit from the bid-ask spread:

  • Bid-ask spread. The bid-ask spread is the difference between the highest price a buyer is willing to pay to purchase an investment and the lowest price a seller is willing to accept as compensation.

When market markers execute trades on behalf of brokerage firms, they pocket the difference between the bid and the ask.

Hypothetically, the PFOF practice works in everyone’s favor: Brokers that outsource the fulfillment of trades can take on more clients. Market makers can trade in higher volumes. And investors can work with experienced brokers that offer commission-free trades.

How does payment for order flow work?

Suppose you hold Microsoft stock and the going market rate is $100 per share. You decide to sell some of your shares, so you submit an order with your broker to sell five shares at $100 apiece. This $100 per share is the ask price.

Next, your broker routes your order to sell five Microsoft shares to a third-party market maker. The market maker prepares to fill your order by matching your interest in selling Microsoft shares with an investor looking to buy. The market marker is successful and finds someone willing to buy your five Microsoft shares — except this investor is so eager to make the purchase, they’re willing to pay $101 per share.

This is the bid price.

The market maker fills your order and pockets the $5 profit between the bid-ask spread. In return for the order, it also pays your brokerage firm — but this typically only amounts to a fraction of a penny per share.

Criticism of payment for order flow

In theory, PFOF should amount to a symbiotic relationship for all parties involved. But it doesn’t always work out that way.

One major criticism of the PFOF model is that brokers may route their customer orders to whichever market makers pay best instead of opting for competitive order execution for their clients — that is, the order execution with the tightest bid-ask spread.

In December 2020, the Security and Exchange Commission (SEC) charged Robinhood for failing to secure the most competitive spreads for its investors while relying on payment for order flow. Its inferior order execution ultimately cost Robinhood investors $34.1 million. Robinhood was asked to pay $65 million to settle the charges.

Another criticism of PFOF? Brokers fail to transparently report their profits from using payment for order flow, despite the SEC’s requirements for them to do so.

Broker reports on payment for order flow can be difficult to find — even on broker websites. With a history of broker and market maker malpractice, these reports are important because they affirm that brokers are operating by the book and with the best interests of their investors in mind.

Payment for order flow and the SEC

After a handful of PFOF scandals erupted in the late 1990s due to broker malpractice, the SEC got involved. PFOF was nearly outlawed, but the SEC determined the practice could continue — after implementing some restrictions.

In 2005, the SEC mandated that brokers participating in PFOF publicly disclose trading details on their websites to encourage transparency and high-quality order execution on behalf of their investors. These rules are known as Rules 605 and 606.

SEC regulatory changes in 2020

Since their inception, the SEC has made several changes to Rules 605 and 606:

  • Rule 605: This rule requires market makers trading specific securities to provide monthly electronic reports on the quality of their executions (on stock-by-stock basis) and how market orders of various sizes are executed relative to public quotes. In these monthly reports, market makers must also disclose information about spreads paid by investors and the extent to which they provide competitive executions.
  • Rule 606: This rule requires brokers to provide monthly reports on net payments they receive from market makers for trades executed in S&P 500 and non-S&P 500 equity trades and options trades. They must also disclose the rate of PFOF they receive per 100 shares, classified by order type.

Should I be concerned about payment for order flow?

Learning about PFOF may make you more cautious as an investor. After all, there’s a lot at stake — and trust is a big factor when choosing to work with a broker.

But not every broker engages in PFOF. And for those that do? Not all brokers that rely on PFOF are abusing it.

4 ways to vet potential brokers before you sign up

One way to ensure you end up working with a reputable broker is by doing some research before you create an account:

  1. Browse the platform’s website in search of disclaimers around PFOF and how the broker makes money.
  2. Email the broker to request copies of the reports mandated by the SEC.
  3. Investigate the brokers reputation on Trustpilot and the Better Business Bureau.
  4. Conduct a Google search for pertinent news reports.

3 brokers that don’t rely on PFOF

Some brokers avoid PFOF by charging a commission — others have adopted an optional tipping model.

If you’re interested in platforms that don’t profit from payment for order flow, explore the following:

  1. Fidelity. Fidelity states that it doesn’t rely on payment for order flow for its commission-free stock and ETF trades.
  2. Public. This zero-commission investing app stopped its PFOF practices in April 2021. Now, Public makes money by earning interest on uninvested cash balances and through its optional tipping feature.
  3. Betterment. Betterment doesn’t profit from PFOF, relying on annual management fees to make money.

Public

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Account types

Brokerage

Account types

Retirement, Robo-Advisor

Asset types

Stocks, ETFs, Cryptocurrency

Asset types

Stocks, Bonds

Bottom line

Payment for order flow (PFOF) practices can be controversial and have recently come under regulatory fire for failing to serve investors’ best interests. Before you sign up for an account, carefully investigate your potential broker’s reputation to find out how they make money.

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