Payment for Order Flow (PFOF) is a trading practice wherein brokers route their clients’ orders to specific market makers or trading firms in exchange for a small payment. This method has become increasingly common, especially among retail brokers, as a way to generate revenue without charging direct commissions on trades. While the concept may seem straightforward, understanding the dynamics and implications of PFOF is crucial for traders who want to optimize their execution quality and overall trading costs.

At its core, PFOF means that when you place an order to buy or sell a security, your broker does not necessarily send that order directly to the public exchange (like NYSE or NASDAQ). Instead, the order is routed to a market maker who executes the trade. In return, the market maker pays the broker a fee, often a fraction of a cent per share or a small percentage of the trade value. This payment compensates the broker for directing the order flow.

The formula to understand how brokers might calculate revenue from PFOF is roughly:

Revenue from PFOF = Number of shares traded × Payment per share from market maker

For example, if a broker routes 1,000 shares of a stock and receives $0.001 per share from the market maker, the broker earns $1 on that order.

A key real-life example of PFOF in action can be seen with popular retail brokers like Robinhood. Robinhood offers commission-free trading and openly discloses that part of its revenue comes from payment for order flow agreements with market makers such as Citadel Securities or Virtu Financial. When a user places an order for a stock or ETF, Robinhood routes that order to these firms, which execute the trade and pay Robinhood a small fee. This model allows Robinhood to offer commission-free trades but has also drawn scrutiny from regulators and the public, especially following the GameStop trading frenzy in early 2021.

One common misconception is that PFOF necessarily means worse trade execution for the retail trader. While it’s true that routing orders away from public exchanges could introduce potential conflicts of interest, brokers who engage in PFOF are still required under regulations to provide “best execution” for their clients. Best execution means the broker must seek to execute orders at the best possible price, speed, and likelihood of completion. Market makers often provide price improvement by executing orders at prices slightly better than the national best bid or offer (NBBO), which can benefit traders.

However, traders should be cautious. Not all PFOF arrangements are equal, and some brokers might prioritize revenue over execution quality. For instance, if a market maker consistently fills orders at prices worse than the NBBO or delays execution, the trader may end up with higher implicit costs than apparent commission savings. This can be especially relevant for high-frequency traders or those placing large orders in less liquid securities.

Another related query traders often ask is: Does PFOF affect the bid-ask spread? The answer is nuanced. Market makers who pay for order flow often internalize the order, meaning they match buyers and sellers within their own system rather than sending orders to public exchanges. This can reduce visible volume on exchanges and might impact liquidity or spread dynamics, especially in less liquid stocks. However, for highly liquid instruments like major indices or FX CFDs, the effect is typically less pronounced.

In summary, Payment for Order Flow is a widespread practice that enables commission-free trading by allowing brokers to monetize order routing. While it offers benefits such as price improvement and zero commissions, traders should understand how it works and monitor their trade execution quality. Being informed helps avoid the pitfall of assuming commission-free always means cost-free, as hidden costs may arise from execution quality or spread effects.