How does payment for order flow work?
Each time you buy or sell shares of stock, your online brokerage routes your order to a variety of different market centers (market makers, exchanges, ATSs, ECNs). In many cases, the market center generates a tiny profit from each retail (everyday investor) order. In return, most online brokers then receive a payment (revenue) from the market maker. This practice of receiving payments from market centers for routing orders to them is called payment for order flow (PFOF).
What is SEC Rule 606 reporting?
Unfortunately, the way 606 reports are structured, there is no universal metric that can be pulled and used to conduct an apples-to-apples comparison between one broker and another.
The SEC requires each broker to disclose certain routing metrics in a standard Rule 606 quarterly report. The most important data that can be extracted from Rule 606 reports are twofold. First, what percentage of orders are being routed where. Second, 606 reports show what payment for order flow (PFOF) the broker receiving, on average, from each market center.
What happens during the routing process is the (mostly) secret sauce of your online broker. This is known as “order execution quality,” or how well your broker executes your order to get you the best possible fill price (the net price paid for the shares). More specifically, brokers seek to achieve price improvement, which means the order was filled at a price better than the National Best Bid and Offer (NBBO). I say, “mostly” because the SEC requires each broker to disclose certain routing and execution metrics in a standard Rule 606 quarterly report.
To keep things simple, the most important data that can be extracted from Rule 606 reports are twofold: what percentage of orders are being routed where, and what payment for order flow (PFOF) is the broker receiving, on average, from each venue. Unfortunately, the way 606 reports are structured, there is no universal metric that can be pulled and used to conduct an apples-to-apples comparison between one broker and another.
Is PFOF bad?
Looking at the big picture, there is nothing wrong with the practice. Revenue from PFOF goes toward paying for all the benefits you take for granted as a customer, including free streaming real-time quotes, advanced mobile apps, high-quality customer support, research reports, etc.
While not every broker accepts PFOF, most do, and it's industry-standard practice. When you went to buy those 100 shares of Apple, your online broker’s routing system tried to get you the best possible price. Depending on where the order is routed, your online broker can earn a very tiny sum of money on your trade, say $0.10 - $0.20 in the case of your 100-share market order.
Some brokers keep PFOF for themselves; others keep a portion of it and pass the rest back to you; and a select few pass all the earnings back to you. You won’t see it as a cash deposit; instead, you will see that your order was executed at an ever so slightly better price (price improvement).
$0.10 - $0.20 may not sound like much; however, if your 100-share market order had been a 1,000-share order instead, that payment could have been $1 – $2, or more. The largest online brokers route hundreds of thousands of client trades every day. Known as daily average revenue trades (DARTs), your online broker can make millions of dollars from routing clients’ orders over the course of each year.
What constitutes PFOF?
Operating a market maker and using an algorithm to pick and choose which customer orders you want to bet against sure sounds like a losing proposition for the customer. However, as long as the broker meets the Best Execution standards, it's perfectly legal, and, it's not technically PFOF. In our view, this sure sounds like profiting from order flow.
How the industry interprets the definition of PFOF is subject to much debate. For example, with options trading, if you think about "payment" more broadly as "profiting," then all brokers accept PFOF for options. More specifically, if the online broker receives rebates from the exchanges they route their customer options traders to (which they all do), then they are profiting from their customer order flow. So, isn't that PFOF? We believe it is, but technically speaking, it's debatable.
Options aside, "What about equities?" you ask. Well, that's a bit more complicated.
Some online brokers own and operate an Alternative Trading System (ATS). These firms technically do not accept PFOF; however, the ATS of each firm is a separate legal entity and is undoubtedly not operated as a non-profit. So, are they generating revenue from their order flow? How does the overall order quality compare to other brokers who do not operate an ATS? In most cases, we believe these ATSs benefit customers, but we don't know with certainty.
Similarly, some online brokerages own and operate a market maker. In their disclosures, they acknowledge that they can internalize orders, meaning trade against their own customer orders. As a result, they keep any profit or loss realized from the trade. Operating a market maker and using an algorithm to pick and choose which customer orders you want to bet against sure sounds like a losing proposition for the customer. However, as long as the broker meets the Best Execution standards, it's perfectly legal, and, it's not technically PFOF. In our view, this sure sounds like profiting from order flow.
All in all, I like to tell new investors that learning how to buy and sell stocks profitably is a life-long game that never ends. I've come to accept that my pursuit of PFOF wisdom is a similar journey.
How do I get the best execution?
As you now know, a variety of factors come into play with your broker’s ability to provide quality order execution. Here is a list of factors in your control that directly impact execution quality:
- What stock is being traded – Companies in the S&P 500, for example, all boast extremely large market caps (they are worth billions) and high average daily volumes of millions of shares per day. This means there is a lot of liquidity (buyers and sellers), which translates into consistently tight spreads (the difference in price between the bid and the ask). On the flip side, a micro-cap stock (or a penny stock traded on a non-major exchange, e.g. OTCBB) that trades only 100,000 shares per day, on average, has little liquidity. As a result, spreads are often very wide, which means you are less likely to obtain a quality, clean fill on your order.
- Time of day – The first 15 minutes of each trading day are statistically the most volatile, meaning stocks fluctuate the most during these times. More specifically, bid / ask spreads are wider, on average. Similarly, pre- and post-market hours have much wider spreads, including far less liquidity, as compared to regular market hours.
- Order type – The most commonly used order type is a market order, which basically says, “buy or sell these shares immediately at whatever the best current market price is.” Limit orders, the second most commonly used order type, on the other hand, say, “buy or sell these shares only at the price I set, or better.” As one can imagine, limit orders may sometimes take longer to fill (if they fill at all), but compared to market order have a higher statistical chance of being filled at a better price. Just be careful, a patient approach using limit orders could result in chasing a stock higher in price.
- Order size – According to the Wall Street Journal, "nearly half of all trades in the U.S. stock market are in odd-lot sizes—in which fewer than 100 shares change hands." However, regulation does not currently cover these odd lot orders, so it is uncertain if everyday investors are getting the best order execution quality. As a result, trading using round lots, e.g., 100 shares, instead of an odd lot, e.g., 57 shares, may result in a cleaner fill from your online broker.
Why does my online brokerage care about order execution quality?
Order execution quality is a very serious business to your online broker. Every big name online broker has a designated team of specialists who analyze client orders in aggregate with a fine-tooth comb. They also consult with third-party consultants (S3, IHS Markit, Best Execution Solutions (BXS), and Abel Noser are the most widely used) to help break down the data. By analyzing the fill quality of the millions upon millions of trades clients make each month, they can use the data to negotiate with different market makers on behalf of all clients.
Think about it: Market makers make money by processing orders. If there are no orders (order flow) routed to them, then they can’t make any money. As a result, market makers compete against each other for order flow, and each online broker chooses which market makers get which orders on our behalf. Your online broker uses this to their advantage for negotiations, as they should.
As we can imagine, the more order flow an online broker has control of, the more negotiating leverage they have with the various market makers. This is where it gets tricky. To attract order flow, market makers will sell online brokers on two key benefits: price improvement and PFOF (remember, this is paying the broker a tiny sum for each order they send). Make no mistake, there is a difference in the order execution quality market makers provide and how much they will pay out in PFOF.
Thus, here is where the real conundrum lies. Should online brokers focus on negotiating for more PFOF, sacrificing price improvement for their clients in the process, or should they focus on negotiating for greater price improvement and sacrifice generating extra revenue on their clients’ order flow? Of many debatable takeaways, this is one topic that the book Flash Boys by Michael Lewis brought into the media spotlight when the book was published in 2014.
So do large brokers have better order execution quality than small brokers? The answer is, it depends. Yes, large brokers have the resources and order flow (size) to negotiate with market centers. However, just because they can measure and better control their routing practice doesn't mean they aren't using that advantage to provide you higher quality fills. Instead, they may just maximize their PFOF.
Are PFOF and execution quality the same?
To understand the relationship between execution quality and PFOF, think of a dial. The more the dial is turned to the left, the more revenue your online brokerage generates off PFOF, and the less benefit your trade receives. Turn the dial to the right and your broker makes less money off PFOF, resulting in price improvement for you (better execution).
Going back to those fancy SEC 606 reports, there is no way to know exactly how each broker’s dial is set. As stated earlier, the reports are outdated and lack universal metrics that allow for direct peer-to-peer comparisons. However, they do require each broker to disclose any PFOF relationship they have with a market maker. They also require each broker to disclose what percentage of clients’ orders, sorted by type, are routed to each market maker.
Using this information, one can take an educated guess (and I mean a guess) as to how each broker has their dial set. Our opinion as to how each broker’s dial is set is an important component of our rating system for order execution quality (see below for ranking methodology and results).
Do large brokers have better order execution quality?
The takeaway here is twofold. First, size matters in negotiating deals. Second, size provides larger brokers a massive advantage over smaller brokers because there is more total execution quality benefit to distribute.
Now that we understand brokers have a theoretical dial they control, we can discuss one final piece of the puzzle – proper tweaking. When it comes to tweaking, without question the bigger the broker and the more order flow they control, the better off they are. There is a measurable advantage to being big.
Why size matters is a simple lesson in economics. Let’s say you have online broker A and online broker B. Broker A is small; it has only 10,000 DARTs (order flow) each day. Broker B, on the other hand, has been in business for several decades and built up a large client base with an order flow of 100,000 daily DARTs. So, let’s say Broker A and B decide to route their orders to exactly the same market makers and both want a balance of PFOF with order execution quality. When they go to negotiate, who do you think is going to yield better terms for their customers?
Without question, Broker B. Why? Because this broker has far more leverage at the negotiating table. Furthermore, Broker B, with its size and larger budgets, has a team of order execution experts (see “The Trade-off” above) to collect data on behalf of clients and make sure each market maker they do business with is keeping their end of the deal in providing consistent price improvement.
The takeaway here is twofold. First, size matters in negotiating deals. Second, size provides larger brokers a massive advantage over smaller brokers because there is more total execution quality benefit to distribute. Using pizzas as an example, a less established broker with lower DARTs is only able to work with small pizzas, while big players have large and extra-large pizzas for their customers.
Are $0 stock and ETF trades good for everyday investors?
Thanks to a September 2019 pricing war, most online brokers cut their baseline stock and ETF commissions to $0 per trade. No question, this was a big win for everyday investors.
By moving to $0 per trade for stocks and ETFs, some online brokers gave up a substantial source of revenue. In fact, the move to $0 cost several online brokerages hundreds of millions in lost annualized revenue. After the news hit, based on Wall Street's response, it was very apparent that tweaking the PFOF dial alone was not going to be able to make up the difference.
While the latest price war was not all cupcakes and rainbows (squeezed margins put fresh pressure on the industry to consolidate further), as far as trading costs go, everyday investors came out on top.
Does order size impact order execution?
According to the WSJ, nearly half of all trades are odd-lot sizes, meaning fewer than 100 shares being traded. Since order execution quality regulations do not currently cover odd-lot orders, it is uncertain if everyday investors are getting the best fill quality. Most industry experts recommend using round lots, e.g., 100 shares, to achieve the cleanest executions.
What is price improvement?
Price improvement means that your buy or sell order was filled at a price better than the National Best Bid and Offer (NBBO). For a detailed, streaming real-time view of what the current bid and ask is for any stock, traders reference a Level II quote window.
What factors affect order execution quality?
There are four factors that every investor can control that will directly impact the quality of their buy and sell orders.
- The stock traded (more liquidity, the better).
- The time of day (avoid trading immediately after the opening bell and during post-market hours).
- The order type used (non-marketable limit orders are best).
- The number of shares traded (try to stick to round lots, e.g., 100 shares).
What are the most common order types?
Market and limit orders are the two most common order types used by retail investors. While every broker has an auto (smart) routing option by default, some brokers offer level II quotes with direct-market routing, providing traders the ability to route their orders wherever they’d like. Taken one step further, some brokers even pass along any market rebates (or liquidity charges) associated with direct market routing. For sophisticated traders, these options can provide positive results if used correctly.
Do any brokers show orders that receive price improvement?
In 2015, Fidelity became the first to begin showing per order and cumulative price improvement across each account (Charles Schwab became the second broker to do so in 2018). For month-to-date, year-to-date, and previous 12-month periods, customers can see exactly how much they paid in commissions, how many trades received price improvement, and the total price improvement. Price improvement means a buy order was executed lower than the best ask or a sell order was executed higher than the best bid at the time of the trade.
Since there is no single universal industry metric yet that identifies order execution quality, we focused our scoring in four areas:
- Payment for Order Flow (PFOF) – Brokers earned points for declining payment for order flow.
- Order execution transparency – Brokers earned points for displaying relevant execution quality metrics on their websites.
- SEC 606 reports analysis – Brokers earned points based on our interpretation of their routing practices.
- Expert interviews – We interviewed professional traders and industry experts to understand their personal experiences and thoughts on order execution quality.
StockBrokers.com 2022 Overall Ranking
Here are the Overall rankings for the 15 online brokers who participated in our 2022 Review, sorted by Overall ranking.
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About the Author
1 Fidelity Sell orders are subject to an activity assessment fee from $0.01 to $0.03 per $1,000 of principal. Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.
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