Recently, a lot of news and debates took over the Share Markets industry and the common term among all these debates was PFOF.
If you don’t know yet, then PFOF has been in practice for decades and you have been a part of it.
So, let’s understand what PFOF actually means and why countries like Canada, the UK, and Australia have banned its practices?
What Is PFOF?
A PFOF means a Payment for order flow.
It is the fees that the commission-free brokerage firms receive in return for delivering their orders to the market makers. This is generally done to maintain the liquidity of the markets.
Let us understand this in detail.
A PFOF comes into play when a consumer places an order using any commission-free brokerage firm. Now, these brokers send these orders to the market makers a.k.a the wholesalers.
But, before sending these orders to the market makers, the brokerage firms charge a very small fee for bringing these orders to the wholesaler. So, if you were wondering how these zero-commission brokerage firms make money, the answer is PFOF.
Let us break this down further and then understand its concept.
The following are the major players who participate during a trade in the stock market:
- Buyer- An individual who wants to buy a stock from the market
- Seller- An individual who wants to sell a stock in the market
- Broker- A company processing the orders of the retail investors instantly
- Market Makers- Wholesalers who execute bulk orders received from the brokers in a fraction of seconds.
So, if you were thinking that you are selling your stocks to another individual, then you are wrong. It is the Market makers who buy or sell your orders.
This means that the orders placed by the retail investors don’t even show up on the public exchanges. In fact, they are privately executed by the market makers.
Now, when the brokers send your orders to these market makers, they charge a PFOF. The sole purpose behind this is to carry out quick trades at high volume without any interference.
How Does It Work?
Let’s look at an example to understand where this PFOF comes in during the trading sessions and why people seem to not notice it.
Assume that you have 200 shares of a particular stock that you want to sell in the markets. Now, the possibility of finding a buyer who is willing to buy 200 shares at the exact same time is very low.
However, you never faced such issues. Know why?
This is because your broker always sends these orders to the market makers, who buy them from you instantly. These market makers execute such orders in a fraction of a second.
But, the problem with this process is the possibility of suffering a loss.
What if the market maker buys your shares and before selling them, the price of the share falls. This will cause heavy losses to the wholesalers. To compensate for this loss and the risk involved, the retail investors are charged a very small amount known as a bid-ask spread.
A spread is simply the difference in the prices of what the buyer is paying to buy the stock and what the seller is receiving to sell the same stock. This difference is generally very low.
Why Is PFOF In The News?
Recently, when the SEC(Securities and Exchange Commission) decided to screen the working of the brokers and the market makers, it found something wrong going in the markets.
The PFOF which is being used to maintain the liquidity of the markets and quick execution of the trades by the retail investors is being used for the broker’s benefit.
The commission stated that there may be a possibility that the brokerage firms are routing the orders of their users to the market makers who can pay them the most PFOF rather than choosing the best market maker for the retail investors.
There is also a certainty that the brokers are encouraging the users to trade more frequently in volumes as it will directly help them generate more commissions through PFOF which is not in the best interests of the users.
The Benefits Of PFOF
It is not like the PFOF only harms the investors or their interests, but there are even some benefits of using it in the stock markets.
Firstly, it maintains the liquidity of the markets. The small brokers who don’t have the capacity to handle bulk orders can pass on these orders to the market makers. Through this, they not only make some profits but also remove the delay in the transactions.
By charging more PFOF, the brokers also have to offer timely rewards or lowered rates to face the intense competition in the markets. This has given improved rates to the investors from time to time.
With the increase in Liquidity due to the quick execution of trades, the bid-ask spread also comes down and eventually benefits the investors in getting their stocks at better prices.
Robinhood, a popular brokerage firm in the US, was generating around $69 million in 2019, but the numbers shot up to $687 million in the year 2020 through PFOF. This shows clearly how the brokerage firms have made so much money through this practice.
Although it has a couple of benefits, PFOF has always been under the radar of controversies. Many brokerage firms offering zero-commission trades often route the orders of their users to the market makers, which was not in the interest of the investors.
Especially in options trading where the spread is quite more than normal equity or spot trading, the brokerage firms were charging a high rate of PFOF. Many investors even reported that their free trades cost them some pennies as they were unable to get the best rate during the time their order was getting executed.
After analyzing the whole operation of the PFOF and the controversies revolving around the matter, it is right to say that the brokerage firms have indeed misused this feature. Starting with the goal of maintaining liquidity and saving the time of the investors, PFOF has become a gold mine for many brokerage firms.
Talking about the inactive investors or traders who don’t frequently trade in the market, it is possible that they do not get affected much by PFOF. However, the frequent traders who invest in volume and large quantities must closely monitor their trades and the PFOF fees involved in the transactions. They should also see the routing of their trades and which market maker is processing their orders.
With the SEC bringing up various concerns and questions for these brokers, it will be interesting to see whether the US will continue to use PFOF in the stock markets or ban it like Australia, Canada, and the UK.