What is payment for order flow and how does Upstream’s smart-contract-powered market avoid it?
By Anastasia Samaras
In the world of online trading, there’s often more happening than meets the eye surrounding opportunities such as commission-free trading, which has ignited some debate within financial circles for its potential implications on market fairness and transparency. At the core of this is payment for order flow.
What is payment for order flow?
Payment for order flow (PFOF) is a form of compensation, usually in terms of fractions of a penny per share, that a brokerage firm receives for directing orders for trade execution to a particular market maker or exchange.¹
Individuals who trade through online brokerage accounts may assume they have a direct connection to the securities markets, wherein you submit your order to a brokerage, then the brokerage delivers your shares. It’s not that black and white. When you submit a trade order from your desktop or through most smartphone trading apps, your order is sent to your broker. In a payment for order flow model, the brokerage then routes that order to a third party known as a market maker, not directly to a public exchange. These third parties then decide on which public exchange to send the order to for execution.
Who are market makers and why do they pay for order flow?
In the financial marketplace, market makers act as market intermediaries, and they decide which market to send orders to for execution. Market makers set the stage with their two-sided quotes. They buy and sell securities at slightly different prices (the bid and ask), capturing the space between their profit — and thespread.²
Market makers need a steady stream of buy and sell orders to fulfill their role as liquidity providers. That’s where payment for order flow (PFOF) comes in. Essentially, market makers pay brokers a small fee for directing investor orders their way. This influx of trades increases their order book depth, potentially allowing them to widen the bid-ask spread — which translates to higher profits.
However, navigating the market is far from a predictable stroll. Price fluctuations pose a constant threat, meaning a poorly timed purchase could leave a market maker holding a depreciating asset. So, it’s a delicate balancing act: managing risk, aiming for wider spreads, and continuously attracting order flow through payment for order flow (PFOF) keeps these financial professionals on their toes.
The murky waters of payment for order flow (PFOF)
While payment for order flow (PFOF) has the potential to reduce costs for investors, as some of the generated revenue can be passed on, regulators like the SEC in the U.S. have raised concerns about the impact payment for order flow may have on quote competition.³ Matching other exchanges’ prices, as seen in options markets, can discourage displaying competitively priced quotes and ultimately widen spreads, increasing execution costs for everyone.
Payment for order flow (PFOF) and internalization may also raise troubling questions about conflicts of interest. Brokers have a fiduciary duty to prioritize their clients’ best execution, yet they also stand to gain financially by directing orders to preferred market makers or internalizing trades for themselves. This can lead to hidden costs for investors, who may not be getting the best possible price or execution if brokers prioritize their profits over clients’ interests.
This lack of transparency around payment for order flow (PFOF) payments leaves retail investors in the dark, unable to gauge potential conflicts of interest. Market makers could potentially exploit this obscurity to widen spreads or execute trades at less favorable prices for retail investors, putting them at a disadvantage.
Upstream’s stance on payment for order flow
There is no payment for order flow on Upstream, a MERJ Exchange market. Upstream is committed to building a transparent trading environment — and that means addressing the concerns surrounding payment for order flow. Here’s how Upstream breaks the mold:
- No payment for order flow (PFOF): Upstream does not engage in payment for order flow (PFOF) practices. Upstream operates with public, on-chain orderbooks, where all bids and offers are shown to users, free of charge.
- Real-time trading and settlement: All Upstream orders are matched and executed peer-to-peer in real-time, ensuring a level playing field for everyone.
- Preventing market manipulation: Smart-contract technology safeguards against predatory trading practices like short selling, protecting both issuers and investors.
- Direct access to the market: Upstream offers direct access to the market through the trading app. This works to allow users to trade without all of the intermediaries that may eat into investors’ returns.
- Equitable access to data: Upstream doesn’t sell real-time trading data to third parties, APIs, or algorithmic trading services. Every trader has equal access to market information.
Upstream is working to usher in a fairer, more transparent trading future. Visit upstream.exchange.
U.S. persons may not deposit, buy, or sell securities on Upstream.
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