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April 2, 2021
Broker-Dealers and Payment for Order Flow
Introduction
The last few years have witnessed an unprecedented surge
in retail investor s ecurities trading at major dis count broker-
dealers such as Robinhood, Charles Schwab, TD
Ameritrade, and E*Trade. Among the factors that have
driven this are the zero trading commissions that many of
themnow charge for trades. The non-existentcommissions
are often subsidized by a controversialrebate to the broker-
dealers called paymentfor orderflow (PFOF).
Market makers, alternatively known as wholesalers, make
cash payments to retail broker-dealer firms in exchange for
marketable retail customer stock order flows. In return for
this PFOF, market makers such as Citadel, Virtu,
Susquehanna, Wolverine, and Morgan Stanley typically
execute the orders in-house, called internalization. Market
makers also pay broker-dealers significant amounts of
PFOF for order flow from stock options-contracts that
give an investor theright, butnotthe obligation, to buyor
sell a stock at an agreed-upon price and date. Such trades
are generally not internalized but are insteadroutedto
options exchanges such as the CBOE Options Exchange.
Figure 1. Aggregate PFOF Revenue from Four Major
Brokerages
Major brokerages included:
TD Ameritrade, Robinhood, $2.5
E*Trade, and Charles Schwab billion
$895
million
2019 2020
Source: CRS,with data fromAlphacution.
Notes: PFOF= Payment fororderflow.
Reporting fromAlphacution, a research firm, indicates that
aggregate PFOF revenue nearly tripled at fourmajor
broker-dealers-TD Ameritrade, Robinhood, E*Trade, and
Charles Schwab-to $2.5 billion in 2020 from $892 million
in 2019. By various accounts, PFOFhas played a
significant role in helping to lower retail broker-dealer
commissions and then helping to usher in the more recent
era of Robinhood-pioneered zero trading commis sions. And
because of this, it has indirectly helped generatea surgein
retail securities investing, which, according to the
investment bank Piper Sandler, grew from 13% oftotal
trading share volume in December2019 to 23% in
December 2020.
Alphacutionalsoreported that stockoptions-whichhave
been described as an accelerant in the speculative trading
ofmeme stocks such as GameStop, AMC, Blackberry,
and Bed Bath and Beyond-accounted for 61% of total
PFOF in 2020.
Market Makers
Broker-dealers receive smallpayments, typically in
fractions of a penny per share, as their compensation for
routing orders to market makers. For major broker-dealers,
those pennies substantially add up. For example, total PFOF
revenue for the first half of 2020 were as follows: $271.2
million for Robinhood, $120.1 million for Charles Schwab,
$189.98 million for E*Trade, and $526.59 million for
Ameritrade.
So why are market makers willing to spend suchsums for
stock order flow? According to Georgetown University
fmance professor James Angel:
[M]arket makers offer to buy from customers at
their bid price and sell to them at a slightly higher
offer or askprice. Competition frommarket makes
and other investors keeps the bid-ask spread
between the bid and ask prices quite small. The
market makers are selling the service of
convenience for investors who want to trade
quickly. They are not long-term investors, nor
should they be. Market makers particularly like to
take the other side of small retail trades because
they know that those retail traders are not
sophisticated institutional investors such as hedge
funds. Market makers know that they can lose when
they trade with large institutions that know more
than they do. Market makers can buy from a retail
order at the bid and sell at the ask or offer and
pocket thebid-ask spread. They don't needto wony
that retail investors as a group have better
information and will dump shares on the market
maker just before bad news is announced.
Competition among market makers for retail order
flow is so intense that market makers are willing to
pay for orderflow and offervarious levels ofprice
improvement-prices better than the nationalbest
bid and offer (NBBO) prices [the best prevailing
offers to sell and buy a given stock across vaious
trading venues].
Best Execution
For decades, PFOFhas been the subject of policy debates
on its merits and shortcomings by regulators, industry
stakeholders, academics, and Members of Congress. The
uproar in the winter of2021 surrounding the behavior of
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