Feb 18, 2021 - Economy

Explaining GameStop hearing terms: Payment for order flow

Nickel with cones in front of it

Illustration: Aïda Amer/Axios

Payment for order flow, or PFOF, sits at or near the top of the list of people's complaints about market structure.

The big picture: The House Financial Services Committee is holding a hearing on Thursday about the trading mania that drove a group of "meme stocks" — most notably, GameStop — to meteoric heights. PFOF is one of the three most important policy issues that are likely to arise during the hearing.

What to know: Every stock trade involves a buyer and a seller. If you're a large institutional investor, your ideal counterparty is a small retail investor who is unlikely to have better information than you do.

  • As retail trading increases, it creates competition for that order flow among high-frequency traders (HFTs), all of whom want to take the other side of the retail trade.
  • That competition takes the form of so-called "price improvement" — better prices than seen on the official stock market exchanges — which in turn gets split between retail investors and their brokers. The broker's slice is the notorious PFOF.

Driving the news: Public, one of the smaller app-based brokerages, announced this week that it had stopped sending its order flow to HFTs in return for PFOF. Instead, it's sending those orders directly to exchanges, even though doing so, the company admits, is more expensive.

  • Normally, if orders are sent directly to exchanges, there's no price improvement at all. But some exchanges, including NYSE, Nasdaq, and BATS, have "retail liquidity programs" where HFTs can once again compete to offer price improvement for what they assume are low-information trades.
  • It's not clear that trading with HFTs via retail liquidity programs will end up giving customers better prices than the status quo of going to the HFTs directly.

How it works: Trades on Public will still be free, but customers will be able to add an optional tip of no more than 5% of the value of the trade.

  • When customers do tip, the tip will almost certainly be substantially larger than the amount that Public used to receive in PFOF. That was about 0.1 cents per share, for S&P 500 stocks — so a $1,300 order to buy 10 shares of Apple would have netted Public about 1 cent.
  • The tip increment on that $1,300 order will start at $1 — 100 times larger than the old PFOF payment. The maximum tip of $65 would be 6,500 times more than the standard payment that Public would previously have received.

The bottom line: The real problem with PFOF is not that it costs customers a lot of money. Rather, it's that it gives brokerages like Robinhood an incentive to maximize the amount that their customers trade, even if that much trading is not in those customers' best interests.

  • The best way to disincentivize trades is to charge for them. Thanks to Robinhood, however, $0 trading commissions are here to stay — even (especially) for highly-risky options trades.

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