October 27, 2022
And, what is payment for order flow?
In the aftermath of brokerages limiting trading in stocks like GameStop and AMC Entertainment, millions of Americans are seeking answers about the brokerage industry.
Namely, they are trying to figure out how brokerages make money, if there is any truth behind alleged conflicts of interest, and whether they can trust brokers with their money.
Ultimately, the reasons behind the trading limitations are still deeply mystifying to many. However, how brokers make money is not so complicated. In this post, we’ll demystify the “big business” of brokerage apps like Robinhood.
How do brokerages make money?
When Robinhood launched in 2015, it turned the brokerage industry on its head. Up to this point, brokers had charged users a commission for every trade that they made. In the years after Robinhood launched, almost every other major broker pivoted to the no-commission model. But how were they making money if not directly charging users?
The simple answer is: there’s a bunch of ways. Brokers could lend shares to people who might want to borrow them, earn interest on uninvested cash balances, offer loans to users to buy stock or funds (margin lending), sell order data, offer a subscription service, or make money by ‘outsourcing’ user trades. How much money is coming from each of these categories is different from broker to broker.
However, one particular element of the brokerage business model has come under scrutiny on social media and in the news since the trading limitations in January 2021. It’s called Payment for Order Flow (PFOF) and, simply put, it’s a way for brokerages to make money by outsourcing trades to third-parties that actually execute them.
What is Payment for Order Flow (PFOF)?
Payment for Order Flow (PFOF) is a system by which brokers divvy out their customers’ orders to third-parties. These third-parties are called order flow providers. For executing your trade for you, they kick back some money to your broker as a rebate. Seems backwards? Don’t worry, they’re making some money off placing your order–somehow.
It might surprise you to know that brokers make a killing on PFOF. From the first to the second quarter of 2020, Robinhood’s PFOF revenue nearly doubled. They made $180.3M in Q2 2020 alone. This is just from rebates issued by order flow providers to brokerages.
All brokerages are required to put the interests of the customer first. But, what happens if a broker’s order flow partner has interests asymmetrical to the customer’s? In the January 2021 GameStop short squeeze, this question was tested.
One of Robinhood’s biggest sources of PFOF revenue came from Citadel Securities LLC, an investment firm that helped bail out Melvin Capital after its GameStop short position blew up. In the days after, Robinhood halted trading – leading many to believe that Citadel’s relationship with Robinhood prompted the trading halt.
Though Citadel categorically denied the claim that it influenced Robinhood or any other broker to halt trading, it still was a bad look. Within a week of the halt, at least one brokerage service announced their plans to pivot from PFOF. Public said that they will turn to a tipping system, hoping that their users will help replace the lost income from PFOF by directly supporting the app.
Will the brokerage business model change?
In truth, it’s hard to know if brokerages will change their ways. Public’s decision to pivot from PFOF is an interesting one, but it is a big swing to take. PFOF has been controversial for over two decades and one of America’s biggest financial regulatory agencies, the SEC, considered banning it outright. They decided against it due to concerns that it could cause brokerage monopolies. However, in 2020, that feels incredibly unlikely given that there are dozens of brokers now.
PFOF is controversial again, but whether it will continue to capture the economy of conversation in the finance world remains to be seen. Regardless, the relationship between brokers and order flow providers needs to be scrutinized. In 2017, Citadel Securities was forced to pay a $22m fine for not getting clients the best price possible. Some of these same order flow providers have high-frequency trading departments, which supposedly sell order flow data to third-parties to allow them to frontrun trades.
In order for there to be change, customers might have to demand it–and, for much longer than a week. If there’s anything we can learn from this, it’s that nothing is “free.” Our no-commission trades have a price. The question is whether or not customers care (or, pay enough themselves) to actually drive change.
A message from Front
Since Front is not a broker, nor do people transfer any assets to our strategic investment platform in order to use it, PFOF has never nor will ever be a part of our business model. But, we watch this story unfolding with interest, since it affects the vast majority of investors–ourselves included. We strive to build a future in which everyday investors have the tools and knowledge they need to win, both now and later. See how the Front app puts the power of data-driven investing in the hands of every investor, for free.