In financial markets payment for order flow refers to the compensation that a broker receives, not from its client, but from a third party that wants to influence how the broker routes client orders.
Contents
In general, market makers such as dealers and securities exchanges are willing to pay a broker for the right to transact with that broker's clients because they believe those clients will be uninformed traders—retail or other investors who are trading because of emotion or the need to raise cash and not because they know an asset is misvalued.
By purchasing what it expects to be uninformed order flow, a market-maker can buy at the bid and sell at the ask with less risk of trading at a loss than with an informed trader who knows that the market is mispricing the security. Thus, market-makers who pay for order flow can capture the spread while reducing the risk that the spread is too narrow to adequately compensate them for the risk of loss.
History
Payment for order flow was a practice pioneered by Bernard Madoff, and the practice has long been controversial. However, on February 27, 2009, after years of opposing payment for order flow, the New York Stock Exchange sought permission from the U.S. Securities and Exchange Commission (SEC) to allow payment for order flow on its electronic exchange(s). The NYSE is proposing to pay for limit orders in order to put more cash into the market. This contrasts with the traditional model of payment for order flow that pays only for market orders. Payment for order flow has become less lucrative on a per share basis because of the decline in the tick size and the bid/ask spread. When stocks traded on 1/8ths of a dollar, payments for order flow were much larger than they became after 2001 when the tick size in U.S. markets fell to one cent. Larry Harris reports that in 1997, 24% of E-Trade's transaction revenue came from payment for order flow, but that by the second quarter of 2001 such payments accounted for only 15% of transaction revenue.
Analysis
The benign view is that in competitive markets, the payments that brokers receive for selling uninformed order flow reduce commissions for retail investors so that the retail investors are no worse off. Payment for order flow may also allow smaller trading venues to compete more effectively with the NYSE.
A more negative view is that exchanges and other market-makers who pay for order flow reduce liquidity on exchanges that do not pay for order flow and thus increase the bid–ask spread. This means that traders whose orders do not receive payment bear the cost to their detriment. Joel Seligman has noted that "Few practices are more likely to subvert quote competition" than payment for order flow. John C. Coffee has described it as a "bribe". He notes, however, that the SEC permits the practice because it sustained competitors to the NYSE and reduces the likelihood that NYSE specialists will obtain monopoly power.
Legality
In the United States, accepting payment for order flow is only allowed if no other trading venue is quoting a better price on the National Market System. Moreover, the broker must inform its client in writing that it accepts payment for order flow: