The Thief of PFOF
A few years ago, we discussed how $0 Commissions were a trap and more recently, introduced hidden costs. In this post, we are going to dig deeper into what has replaced broker commissions in trading, otherwise known as Payment for Order Flow (PFOF). The thief of PFOF is nefarious and represents the new way that retail investors are being tricked and deceived and ultimately, being cheated out of their investing dollars.
Recently, Better Markets did an interview where they described in great detail the issues with PFOF. Check out the Youtube link here. On top of that, Robinhood’s recent June 2021 IPO filing has disclosed that 81% of its first-quarter revenue came from sending its customers’ stock, options, and cryptocurrency orders to high-speed trading firms – a practice known as payment for order flow (see link here).
Payment for order flow critics—including the country’s top market regulator, Securities and Exchange Commission Chairman Gary Gensler —are wary of the practice. They argue that it poses a conflict of interest for brokerages, because the brokers can either collect more money for selling their customers’ order flow or pass that money on to customers in the form of price savings on their trades.
Per Better Markets:
The frenzied trading in GameStop and other so-called “Reddit Rebellion” equities has brought attention to longstanding equity market structure issues. In particular, retail broker-dealer Robinhood Markets Inc.’s
(“Robinhood”) order routing practices have—again—come under regulatory and public scrutiny. In 2020, Robinhood reportedly received $687 million dollars in so-called “rebates” for essentially selling its customers’
orders to six high frequency trading (“HFT”) firms that serve as its executing broker-dealers (i.e., the HFTs that execute or facilitate the execution of Robinhood’s customer orders). These rebates, called “payment-for-order flow” (“PFOF”), are used by nearly all of the “commission-free” retail broker-dealers (e.g., Robinhood, E-Trade, Schwab/TD Ameritrade) who receive orders from Main Street investors. PFOF across all retail broker-dealers in
2020 was reportedly $2.6 billion.
Of course, the HFTs were willing to rebate $2.6 billion to retail broker-dealers because execution of retail customer orders generated net trading profits of more than the rebated amount. The key question raised by
these practices is whether retail customers end up worse off in a material number of securities transactions routed to the HFTs because of the PFOF. Despite often inaccurate or incomplete HFT-industry claims to the contrary,
the answer to this question is “yes.”
The essential facts about PFOF are as follows:
- Conflicts of Interest: First, PFOF creates conflicts of interest between (1) a retail broker-dealer’s duty to seek the “best execution” available for customer orders and (2) its duty to maximize its own profits for shareholders and/or owners through PFOF revenues generated by preferentially routing transactions to select HFTs. The regulatory standards governing “best execution” are multi-factor, malleable, and difficult for regulators to monitor, much less enforce, making them an inadequate mitigant for these conflicts of interest.
- Harm to Investors: Second, these conflicts, in practice, have been found to affect order routing decisions and harm Main Street investors. This is evidenced, for example, by a recent Securities and Exchange Commission (“SEC”) enforcement action finding that Robinhood executives internally reviewed the firm’s order routing practices, determined that limiting order routing to the PFOF executing dealers was harming its customers, and yet, continued to preferentially route orders to those dealers. Robinhood paid a $65 million civil monetary penalty for failing to disclose those practices to its customers—the facts are damning and seem to indicate that the firm intentionally concealed the adverse effects of PFOF from its customers. Robinhood did not admit or deny the SEC’s findings in connection with that enforcement action.
- Harm and Risks to Markets: Third, PFOF takes retail customer orders and transactions (referred to as “liquidity”) away from transparent securities exchanges and redirects that order flow to a very small number
of HFTs that execute an almost alarming percentage of overall trading. This lost liquidity (1) affects all investors directly or indirectly using the securities exchanges, (2) potentially disincentivizes the provision of resting liquidity to the exchanges, (3) has serious and potentially systemic risk implications, (4) incentivizes, if not requires, exchanges to design distortive liquidity rebates and programs, order types, and trading protocols to
attract and advantage trading originating with these HFTs; (5) results in a needlessly fragmented system of created complexity that lacks sufficient transparency and investor protections; and (6) interferes with the price
discovery and capital allocation functions of the securities markets.
It is noteworthy that other jurisdictions, including the United Kingdom, Australia, and a few European Union member states, have prohibited payment for order flow without adverse consequences.
Citadel Securities (“CS”), like other HFTs, repeatedly cites exaggerated and misleading “price improvement” statistics meant to quantify the supposed value of PFOF and internalization to investors. CS recently stated, for example, that it provided $1.5 billion of “price improvement” on retail equity orders in 2020. This misleading figure leaves out the inconvenient facts that can found in full detail here.
FINRA has also recently sent out notice reminding firms of requirements concerning best execution and payment for order flow.
Most brokers are only identifying good-enough prices and good-enough execution, not best execution.
When Citadel or Virtu gets an order from a retail broker, they have a profit margin on that order. Let’s say the spread is $0.02 wide, and they think they can make $0.015 per share, on average. Of that $0.015, they want $0.01 per share as profit to keep, and are willing to pay back $0.005 per share to the broker. (all of these numbers are made up, for illustrative purposes)
Citadel and Virtu don’t care if they are sending that $0.005 per share to the broker as price improvement (where the retail investor receives it) or payment for order flow (where the broker receives it).
FINRA is saying that brokers CANNOT negotiate higher payment for order flow instead of price improvement. This is actually a big deal, because it’s the foundation of Robinhood’s business model. If they have to provide the same price improvement as, say, Fidelity, who doesn’t accept PFOF, then they’ll go out of business. The fundamental paradox between a firm that accepts PFOF and one that doesn’t is that the firm that doesn’t gives its customers better execution prices, and therefore better execution. So a firm that accepts PFOF, by definition, cannot be providing best execution. It’s mathematically impossible.
Hopefully we see regulatory groups do something positive to stop PFOF but until then, you are at least more informed on the thief of PFOF. Schedule your free consultation with us here if you want to make sure you aren’t being taken advantage of any more.
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