Payment for order flow

Based on Wikipedia: Payment for order flow

Bernie Madoff loved it. Regulators have tried to ban it. And it's the reason you can trade stocks on your phone without paying a dime in commissions.

Payment for order flow—the practice that made Robinhood possible and sparked congressional hearings—is one of Wall Street's most contentious innovations. To understand it, you need to understand something counterintuitive: your stock trades are worth money to people you've never heard of, and they're willing to pay for the privilege of executing them.

The Hidden Economy of Your Trades

When you tap "buy" on a trading app, your order doesn't go directly to the New York Stock Exchange. Instead, it goes to your broker—Robinhood, E-Trade, or whoever—and they face a choice. They could route your order to a public exchange, or they could send it to a market maker.

Market makers are firms like Citadel Securities, Virtu Financial, and Susquehanna International Group. Their entire business model revolves around standing ready to buy and sell stocks all day long. They profit from the bid-ask spread—the tiny gap between what buyers are willing to pay and what sellers will accept.

Here's where it gets interesting. Your order, as a retail investor, is surprisingly valuable to these market makers. More valuable, in fact, than orders from big institutional investors like hedge funds and pension funds.

Why? Because of something called adverse selection.

Why Your Ignorance Is Worth Money

Imagine you're a market maker, and two orders come in to buy Tesla stock. One is from a hedge fund with a team of analysts who've been studying Tesla for months. The other is from someone who just heard about Tesla on a podcast and decided to buy some shares.

Which order would you rather fill?

The hedge fund probably knows something. Maybe they've analyzed Tesla's supply chain, or they have a sophisticated model predicting next quarter's earnings. If they're buying, there's a decent chance the stock is about to go up—which means you, the market maker, are about to sell them shares that will become more valuable.

The retail investor, on the other hand, is probably just... investing. They're not trading on secret information. They're not trying to outsmart the market. They just want to own some Tesla stock. This makes their order much safer for the market maker to fill.

This informational asymmetry—the fact that retail traders generally don't know more than the market—makes retail order flow valuable. Market makers can fill these orders with much less risk of getting picked off by someone who knows something they don't.

So valuable, in fact, that market makers are willing to pay for it.

The Three-Way Split

Payment for order flow, or PFOF as the industry calls it, works like this: a market maker pays a broker a small amount—typically a fraction of a penny per share—for the right to execute that broker's customer orders. The broker pockets this payment. And sometimes, a portion flows back to the customer in the form of "price improvement."

Price improvement sounds abstract, but it's concrete. Say you want to buy a stock that's trading at $50.01 on the public exchange. The market maker might fill your order at $50.005 instead. You save half a cent per share. Multiply that by millions of trades, and it adds up.

The market maker profits from the spread. The broker profits from the payment. And theoretically, you profit from the better price.

Everyone wins. At least, that's the argument.

The Robinhood Revolution

In 2014, a startup called Robinhood Markets introduced something radical: no-commission stock trading. At the time, you'd typically pay $7 to $10 per trade at a traditional brokerage. Robinhood charged nothing.

How could they afford this? Payment for order flow.

By routing customer orders to market makers willing to pay for them, Robinhood generated revenue without charging customers directly. The model was controversial from the start, but it was undeniably popular. Millions of young, first-time investors flocked to the app.

The rest of the industry had no choice but to follow. By 2019, Charles Schwab, TD Ameritrade, E-Trade, and others had eliminated trading commissions entirely. An era had ended. PFOF had killed the brokerage commission.

By 2020, payment for order flow had become a $2.5 billion annual business.

The Kickback Problem

Critics have a less flattering name for payment for order flow. They call it a kickback.

The concern is straightforward: if brokers get paid to route orders to specific market makers, whose interests are they really serving? The customer's? Or the market maker offering the highest payment?

This isn't theoretical. In 2014, the United States Senate Homeland Security Permanent Subcommittee on Investigations, led by Senator Carl Levin, held hearings on the practice. An executive from TD Ameritrade said something remarkably candid under oath: the company routes orders to wherever it can get the highest payment.

Not the best execution for customers. The highest payment for the broker.

Now, in the broker's defense, regulations require them to seek "best execution" for customers. But "best execution" is a slippery concept. It could mean the best price. It could also mean the fastest execution. Or the most reliable fill. The ambiguity creates wiggle room.

The GameStop Moment

Everything changed in January 2021.

A group of retail traders on Reddit's WallStreetBets forum decided to pile into GameStop, a struggling video game retailer that hedge funds had bet against. The stock went parabolic. From under $20 at the start of January, it rocketed past $400 at its peak.

Then Robinhood stopped letting customers buy GameStop.

The company said it faced a liquidity crisis—regulatory requirements meant it needed to post massive amounts of collateral it didn't have. But the optics were terrible. Retail traders saw a rigged game: they could only sell, while the hedge funds betting against GameStop could keep trading.

Suddenly, everyone wanted to know how Robinhood actually made money. Payment for order flow entered the public vocabulary.

Congressional hearings followed. Regulators questioned whether retail traders were really getting the best possible prices, or whether the whole system was designed to extract value from unsophisticated investors. Some platforms, like Public.com, announced they would abandon PFOF entirely.

The Madoff Connection

Payment for order flow has an uncomfortable origin story. One of its earliest and most vocal champions was Bernard Madoff.

Before Madoff became infamous for running the largest Ponzi scheme in history, he was a legitimate pioneer in electronic stock trading. His firm, Bernard L. Madoff Investment Securities, was an early market maker that pioneered automated execution—and pioneered paying brokers for order flow.

Madoff's argument was that PFOF increased competition. By routing orders away from the New York Stock Exchange, he claimed, the practice broke up a monopoly and gave investors better prices. There was logic to this. The NYSE had dominated stock trading for centuries, and its specialists—the human market makers who controlled trading in individual stocks—weren't always known for giving customers the best deals.

But there's something darkly ironic about the architect of history's biggest financial fraud championing a practice that critics call a kickback scheme.

The Regulatory Patchwork

Different countries have reached different conclusions about payment for order flow.

In the United States, PFOF is legal but regulated. Brokers must disclose that they accept it. Orders must be executed at the best available price—no other exchange can be quoting a better price on the National Market System. And since 2001, the Securities and Exchange Commission's Rule 606(a) has required quarterly public reports on order routing practices.

The SEC has tightened these rules over time. In 2018, amendments expanded disclosure requirements. In 2024, new rules required better disclosure about execution quality. The regulatory trend is toward more transparency, not less.

Europe took a harder line. The European Union banned PFOF outright. So did the United Kingdom.

Canada split the difference. Canadian brokers cannot accept payment for order flow on Canadian-listed securities—which is why Canadian brokers still charge commissions. But they can accept PFOF on American stocks and other non-Canadian securities.

This patchwork reflects genuine uncertainty about whether PFOF is good or bad for investors. Reasonable people disagree.

The Academic Verdict

Does payment for order flow actually hurt retail investors?

Research published in August 2022 by economists at the University of California system tried to answer this definitively. Christopher Schwarz of UC Irvine, Brad Barber of UC Davis, and Terrence Odean of UC Berkeley analyzed whether PFOF affected price execution for retail customers.

Their conclusion was surprising, at least to critics of the practice: PFOF doesn't appear to harm retail investors. In fact, market makers frequently give retail orders better prices than what's quoted on public exchanges. When you sell, you get slightly more per share. When you buy, you pay slightly less.

This doesn't mean PFOF is purely benevolent. Market makers are still making money—they wouldn't pay for order flow otherwise. The question is whether the arrangement leaves retail investors better or worse off than the alternatives.

The economists' answer: not worse off.

The Conflict That Won't Go Away

Even if retail investors aren't obviously harmed by PFOF, something about the practice feels wrong to many people. Your broker has a financial incentive to route your orders to whoever pays the most, not whoever serves you best. Those incentives might align most of the time, but they don't have to.

This is the conflict of interest at the heart of payment for order flow. It's why senators hold hearings. It's why European regulators banned it. It's why, even after academic research suggests the practice doesn't hurt investors, the debate continues.

There's also a deeper question about what we want our financial markets to look like. Should trading be free? Americans have decided yes, and PFOF makes that possible. But free trading also encouraged a generation of investors to treat the stock market like a casino—buying meme stocks, chasing short squeezes, gambling on options.

The brokerages that pioneered commission-free trading made it easier than ever to invest. They also made it easier than ever to speculate. Whether that's good or bad depends on what you think markets are for.

The Invisible Subsidy

Here's another way to think about payment for order flow: it's a subsidy from institutional investors to retail investors.

Market makers are willing to pay for retail order flow precisely because retail traders are less informed. They're not competing against algorithms or research teams. They're just ordinary people trying to build wealth. That informational disadvantage, paradoxically, makes their orders more valuable—and that value gets passed back to them through free commissions and price improvement.

Meanwhile, institutional investors face a market full of other sophisticated players, all trying to gain an edge. They pay the costs that retail investors don't.

This is almost the opposite of how critics frame PFOF. Instead of Wall Street exploiting Main Street, you could argue that unsophisticated retail traders are getting a better deal precisely because they're unsophisticated. Their ignorance is, in a strange way, an asset.

Whether this framing is correct—or just a clever rationalization—is the question that regulators, academics, and market participants continue to debate. The controversy over payment for order flow isn't going away anytime soon.

What's clear is that free trading comes with hidden trade-offs. Nothing in finance is ever truly free. The question is who pays, how much, and whether they know it.