Payment for order flow transfers trading profits from market makers to the brokers that route customer orders to specialists for execution. In simple terms, it is the compensation a broker receives for routing trades to specific entities for trade execution.
Retail brokers send client orders to market makers, who, in turn, commit to provide the retail brokers’ liquidity at the current national best offer (when the investor is buying) or national best bid (when the retail investor is selling) —or better!
Hidden trading fee
PFOF accompanies most commission-free brokers, enabling them to reduce investment costs for clients.
With PFOF, online brokerages such as Charles Schwab, TD Ameritrade, Robinhood receive a fraction-of-a penny payment in exchange for sending orders to wholesale brokers such as Citadel Securities, Virtu Financial or Two Sigma for execution at the best publicly available price displayed across all U.S. exchanges.
Entities such as market makers or wholesale brokers pay retail brokers to direct orders and generate profit from order flow using other means such as bid-ask spreads. For example, they make money by selling a stock for a slightly higher price than they bought it for. They may also trade against the investor’s order by selling shares short and driving the price down.
Some argue that without payment for order flow, brokers would still send trades to market makers, but without a split of the spread, they'd have to charge retail investors.
Diminishing quality of order execution
Typically, your broker should be routing your trade to the exchange/market maker who can provide the best execution but instead is likely to route your order to the one paying more for your order flow.
PFOF may result in lower quality order execution, leading to higher buy prices and marginally lower sell prices. Brokerages choosing PFOF may not always have their customer’s best interests in mind.
The process creates the appearance of a conflict of interest by giving firms an incentive to encourage frequent trading by their clients, inviting subsequent criticisms! The more clients trade, the larger the order flow a broker-dealer has available to sell.
PFOF has been banned in the UK since 2012 as the FCA concluded that it undermined transparency and efficiency when it came to price execution. It was also deemed a conflict of interest for brokers, who would rather deal with market-makers than provide their best effort to their clients.