During the House Financial Services Committee's Thursday hearing on the recent GameStop stock frenzy, there was talk of a practice known as "payment for order flow" (PFOF). To anyone not fluent in the language of finance or the stock market, that might scan as somewhat impenetrable jargon, but here's what you need to know: That's how brokers like Robinhood make money.
Robinhood CEO Vlad Tenev brought up PFOF in Thursday's hearing, following a question from Oklahoma Congressman Frank D. Lucas about how Robinhood and other brokers generate revenue. Tenev also mentioned PFOF in his prepared remarks for the hearing, which were released online in advance of his appearance before the House Financial Services Committee.
"As disclosed to customers and the public, Robinhood Securities receives what is called 'payment for order flow' to route trades to market makers that generally offer better prices than those available on exchanges," Tenev's prepared statement reads. "Most retail brokerage firms receive payment for order flow, and subject to certain disclosure requirements, the SEC has permitted payment for order flow for decades."
Despite Tenev's brief explanation, PFOF might still be confusing to the average amateur trader who may have only downloaded Robinhood in the past few weeks, in the hopes of getting rich off skyrocketing GameStop shares.
A 2000 Securities and Exchange Commission (SEC) study defined PFOF as "a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution." Put simply, it's a small payment that brokers receive from market makers (like Citadel) for directing an order to a certain party, according to Investopedia.
After a trader places an order with a broker, the brokerage firm sends the trade to a market maker to execute and finalize the trade, and the broker receives a PFOF, almost as a perk, from the market maker. The payment for order flow can be negotiated between the broker and market maker.
Citadel CEO Kenneth C. Griffin described PFOF in a similar manner in his own prepared remarks ahead of the hearing, calling it "a longstanding, transparent and regulated practice." He also noted that PFOF is a "key reason" that retail investors can trade with little to no commission fees.
Critics of PFOF say that it invites conflicts of interest. The 2000 SEC study states: "However, payment for order flow and internalization create conflicts of interest for brokers because of the tension between the firms' interests in maximizing payment for order flow or trading profits generated from internalizing their customers' orders, and their fiduciary obligation to route their customers' orders to the best markets."
Investopedia explains that the SEC requires firms to disclose PFOF policies and relationships they may have with market makers; firms must also notify clients of any payments that come from order flow, both annually and when a client first creates an account with a firm.
As noted by CNBC, there's debate among experts as to whether PFOF is hurtful to retail investors. Where exactly the House Financial Services Committee falls on that issue remains to be seen.
Uncommon Knowledge
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Newsweek is committed to challenging conventional wisdom and finding connections in the search for common ground.
