payment for order flow

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Payment for Order Flow

A payment that a dealer makes to a brokerage in exchange for the brokerage sending business the dealer's way. For example, if a brokerage's client offers to sell 2,000 shares of a stock, the brokerage may receive a payment for order flow of three cents per share if it sells the stock to a certain dealer. Brokerages and dealers make payment for order flow arrangements ahead of time; they are advantageous to brokerages because of the revenue, while they enable dealers to make transactions they might not have made otherwise. Critics contend that this system encourages brokerages to act in the best interest of themselves (or the dealers), rather than their clients.

payment for order flow

The payment by a dealer to a broker acknowledging the broker's routing of customer orders to the dealer. For example, a specific market maker on a regional exchange might agree to pay a brokerage firm 2¢ per share for orders directed to the market makers. Payment for order flow has been criticized as an incentive to brokers to send orders to dealers from whom the brokers will receive the highest payment rather than to dealers who would provide the customer with the best available price.
Case Study In October 1995, Charles Schwab Corporation announced the firm would end the practice of payment for order flow. Schwab officials said the firm had been paying about 125 brokerage firms an average of 2¢ per share to route customer orders to its Mayer & Schweitzer subsidiary, which at the time was processing approximately 8% of Nasdaq's daily volume. The announcement came at least partly in response to pressure from both the Justice Department and the Securities and Exchange Commission. The concern was that payment for order flow raised questions about whether customer orders were receiving fair treatment; brokerage firms might send the orders to dealers who offered the highest payment for order flow rather than to dealers offering the best price to the customer. Shortly after the Schwab announcement, Merrill Lynch disclosed that the firm would stop automatically sending small orders for New York Stock Exchange-listed securities to the Boston and Pacific stock exchanges where it maintained dealer operations. Merrill said it would continue to send customer orders to the regional exchanges but only if these exchanges offered the best prices.
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All this information that is compiled may be an extremely profitable source of information on trading behaviours and strategies of other participants--especially when payments for order flow are present.
Already in 2012, the UK's supervision body (at the time FSA) introduced guidelines regarding Payments For Order Flow considering them to generate conflict of interest.
As far as the European continent is concerned, guidelines and regulations from both FCA and ESMA try to restrict the practice of Payments For Order Flow as much as possible since, as a FSA guidance rule on Payment For Order Flow states, this is a harmful process for which its arrangements "create a clear conflict of interest between the clients of the firm and the firm itself" (FSA, 2012).
If so, then just like with maker-taker fees, payment for order flow could create a genuine agency problem by aligning brokers' incentives with receiving payments for order flow, whereas better execution may be obtained on an exchange.
Others, known as rebate traders, profited from payments for order flow the exchanges offered.
By answering those questions, we can better analyze the practice of offering payments for order flow.
Brokers who receive payments for order flow will tend to route orders to whoever offers the largest payments.
In the case of payments for order flow, the purported market failure -- an alleged conflict of interest between brokers and investors -- is, in reality, the unintended byproduct of the current regulatory structure.
With an increasing number of e-brokerages charging minimal or even zero commissions, e-brokerages are more likely to seek revenue, including payments for order flow, from other sources.
Marx, 1997b, "Payments for Order Flow on Nasdaq," University of Rochester W.E.
In addition, the "product" or service provided is not necessarily homogeneous because market makers may offer cash payments for order flow and other noncash services.