What does pfof (Payment for order flow) mean to your order in a fintech solution? And yes it’s still free to you
Can payment for order flows affect your orders when trading?
Technology’s revolutionizing power has changed the financial landscape. Brokers and market makers have had to improvise in order to keep up. One of these improvisations has been the wide-spread adoption of a practice that still draws frowns from more conservative clients and traders — payment for order flow (PFOF).
What is PFOF?
According to the United States Securities & Exchange Commission (SEC), “Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”
Put another way, brokerage firms enter into mutually beneficial agreements with third parties who compensate them with benefits that range from non-monetary services to direct cash incentives. This symbiotic relationship has evolved over the last 30 years and albeit still controversial is now legally recognized.
The legal framework surrounding PFOF
PFOF is now a legal process within the financial world. However, because of its association with the fraudster Bernard Madoff, former investment advisor and non-executive chairman of the NASDAQ stock market it still has unsavory connotations within the industry.
In order to protect clients, brokers are now required to disclose to their clients any contracts they have in place with market makers. This should be done when the brokerage account is opened and annually. Additionally, brokers must also inform clients when PFOF occurs on trade confirmations.
A broker may present you with two reports detailing PFOF statistics and execution quality. These documents are Rule 605 and Rule 606. If the broker does not furnish you with them, they can oftentimes be downloaded directly from their website.
Does PFOF affect your order as a client?
Clients trading equities and options through established brokerage firms are not affected by PFOF. This is because by their very nature, PFOFs are arrangements between your broker and third parties whereby they have a mutually beneficial relationship.
The third parties are the ones that pay the broker. The brokers do not take any additional fees from your investments as a client. Legally, if the brokerage firm you have selected is in agreement with third parties, they should disclose this information to you when you open your brokerage account.
Why brokerage firms enter into PFOF
It makes financial sense for smaller brokerage firms to route their orders through market makers when they cannot manage the influx of orders on a daily basis. In this sense, brokers make money from two ends — from the client and from the market markers.
The biggest conundrum with this practice is the obvious conflict of interest that often arises. This is one of the reasons brokers are now required to report their PFOF policies to their clients.
Are you eager to read more about what’s happening in the Fintech industry? Check out my blog Top 3 Fintech Trends to Watch Out for Next Year.