Payment For Order Flow Explained: Why Zero-Commission Trades Aren't Really Free

Robinhood’s zero-commission trading model came under scrutiny earlier this year during the WallStreetBets-fueled trading frenzy in GameStop Corp. GME and other so-called “meme” stocks. The zero-commission model is not a new concept on Wall Street.

Here’s how it works.

Payment For Order Flow: The core idea of the zero-commission model is payment for order flow, or PFOF. Here’s a breakdown. 

First, an investor submits an order to buy or sell a stock through Robinhood or another online trading platform. That order is then passed along to a third-party “market maker,” the entity responsible for actually performing the transaction.

In return for receiving the order, the market maker pays the trading platform a small fee. When the market maker executes the trade, it will buy the shares at a discount to the price at which it sells them, pocketing the difference. That difference is known as the bid-ask spread.

Robinhood and other trading platforms have figured out that they can make more money selling customer orders in the current climate than by charging small fees directly to customers for each trade.

Related Link: Market Experts React To GameStop Hearing: 'Congress Needed To Dig Deeper'

The Problem With PFOF: Benzinga PreMarket Prep co-host Dennis Dick has frequently discussed the progression to commission-free trading. The idea of buying order flow isn't a new idea, he said. 

In fact, he said one of the first people to employ the technique is now one of the most infamous Wall Street names of all time: Bernie Madoff, who died Wednesday at 82. 

Madoff "created payment for order flow back in the '90s, and then everybody got involved," Dick said. "But it was big orders back then. Now it's every little 100-share lot."

Madoff's idea of purchasing order flow has served to reduce commission fees to zero, but it has increased market spreads, particularly among small-cap stocks, and tilted the trading game even more against the average retail trader, in the PreMarket Prep co-host's view. 

No Free Lunch: While PFOF may seem like a win-win for Robinhood users, Dick said there’s no such thing as a free lunch on Wall Street.

“Off-exchange market makers make payments to retail brokers for the privilege of having their customer's orders routed to them first. The market maker will execute directly against the retail order [if they think they can make money from it]. They are basically paying for the privilege of having ‘first dibs’ to trade against the ‘dumb money,” Dick said.

Retail brokers can also collect liquidity rebates that are paid out by the public exchanges.

“In some cases, these rebates are as high as .003/share, meaning a 1,000-share order providing liquidity would be worth $3 to the retail broker,” Dick said.

Themis Trading's Joe Saluzzi told Benzinga that retail traders are ultimately getting stuck with worse prices on their orders.

“These orders will never make it to the public market because they are intercepted by the market makers. This concerns me since it limits the diversity of the order flow in the market and could damage the price discovery process,” Saluzzi said.

Benzinga’s Take: PFOF is akin to a hidden trading fee. Rather than the old model of charging traders a flat, upfront fee for each trade, online brokers are now simply selling their order flow to market makers, potentially resulting in lower selling prices and higher purchase prices for their users.