PFOF (Payment for order flow)
Order flow payment (Payment for order flow: PFOF) involves retail brokerage brokers, such as Robin Hood (ticker: HOOD) and TD Ameritrade (has been acquired by Charles Schwab, ticker: SCHW) to sell their customers’ market orders to third parties (represented by Citadel Securities and Virtu Financial), the third party executes these orders and earns fees from them, and pays a portion to Robin Hood or TD Ameritrade as payment for routing customer orders to that particular third party.
Citadel Securities paid tens of millions of dollars for this order flow, but made money by automatically accepting the other side of the order and then returning to the market to flip the transaction. It collects the difference between the buying and selling price into the bag, which is called the spread. Citadel Securities alone handles 27% of U.S. stock trades and 40% of U.S. retail trade volume.
Retail brokerages and securities firms sell customer trading transaction privacy for their own interests. Each customer’s transaction details are sold to a third party. This may cause the third party to do the opposite according to the customer’s transaction details and easily profit from it, causing customer losses.
Order flow payment is when the retail brokerage brokers transfer orders to market makers for execution and profit from it. It is Robin Hood’s main source of income, and it is also the reason why this online brokerage, which is popular with young people, can provide commission-free transactions.
There is a conflict of interest in this business. Although market makers can earn part of their income from each transaction, they also allow irrelevant persons to grasp first-hand information, data, etc., resulting in unfair trading markets.
The United Kingdom, Australia, and Canada have all banned order flow.
The Chairman of the US Securities and Exchange Commission (SEC) Gensler has stated that controversial businesses that will bring substantial revenue to brokers and high-frequency trading companies may be completely banned. The option to completely ban order flow payments is inevitable. After Gensler was appointed by President Biden as the chairman of the SEC, it was rumored that the primary goal of his regulatory spearhead was to point to payment for order flow.
The retail brokerage brokerage firm Robin Hood and Charles Schwab will all be affected. Robin Hood is especially one of the representative dealers. Order flow payment is when retail brokerage brokers transmit orders to market makers for execution and profit from it. It is Robin Hood’s main source of income, and this online brokerage, which is popular with young people, is able to provide commission-free.
Charles Schwab is still the largest retail brokerage firm in the United States (if included in retirement accounts, Fidelity Investment users will exceed Charles Schwab), but the impact on Charles Schwab is relatively small, because Charles Schwab’s revenue sources are distributed as follows:
- Retail Brokerage Brokerage: 14%
- Wealth management: 41%
- Banking business: 40%
As for another well-known Interactive Brokers (ticker: IBKR), the impact is slight, because most of its business still requires commissions.
How big are the benefits?
Charles Schwab signed an 8-year contract with UBS (US stock code UBS) in 2005 and sold its customers’ order transaction data to UBS for US$ 280 million “only”. However, the industry generally believes Charles Schwab has taken a big hit. It is a loss because it is the largest retail trader with the most customers. This information is not only the price tag, but UBS must add at least one billion U.S. dollars to it to be reasonable. Please note that this is 2005, and the price is now higher.
Is it really zero fee?
Based on my own experience, it’s true that the purchase is zero dollars, but the sale may be due to account clearing fees, so there will still be a few cents and a negligible fee. If these cents are not counted, It is true that it is free from the record of the trading account.
Any additional fees for online brokers?
From the general trading of US stocks, it is true that online brokerages now have zero handling fees. But we must also consider the following related necessary expenses:
- Converting non-U.S. dollars to U.S. dollars: Banks or foreign exchange chambers will convert your non-U.S. dollars to U.S. dollars according to the exchange rate. If the amount is too small, the foreign exchange companies usually charge fees directly with the quoted price. Basically, you will lose a lot of principal when you exchange foreign currencies. This is basic common sense; if you don’t believe it, if you exchange your money for US dollars and then immediately exchange it back, you will know how much you will lose.
- Deposit US dollars into your online brokerage account in the United States by wire transfer; calculate your funds wire transfer fee based on the amount you send out, plus a minimum single wire transfer fee (different from banks, about US$ 30) .
- U.S. dollars will be remitted to your online brokerage account in the United States, and your online brokerage company will deduct an additional charge, approximately US $25.
Regarding the various ways of investing in U.S. stocks and the differences between them, please refer to my other blog post “How to invest in US stocks? sub-brokerage, and fintech companies“.
There is a book called “Flash Boys: A Wall Street Revolt (2014)”, written by Michael Lewis, who won the best American business book of the year, is discussing the subject of this article. Those who are interested can refer to it.
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