History of Payment for Order Flow

One thing stands out as a thorn in the side for daytraders, Payment for Order Flow (POF).  POF has been present in United States markets for quite a long time now, as it is a common practice going back to the 80’s where master manipulators like Bernie Madoff fine-tuned the practice for the benefit of POF firms.  POF occurs when a third-party firm pays a brokerage firm to send their orders to them, rather than to the open market.

The POF firm can take the order and either execute it themselves, or pass it on and send to the market for fulfillment against other existing quotes.  The majority of the trades passed onto POF firms are retail trades, which POF firm especially enjoy, as the retail trader is not as knowledgeable of the market and its inner workings.  The typical retail trader does not see true-real time market prices and they remain relatively uniformed. 

Current Regulations

Rules 10b-10, 606 & 607 under the Exchange Act dictate that when these transactions occur, the broker-dealer is obligated to disclose the agreement in public quarterly reports, and also to the customer.  The broker is also required to execute the trade with the best price according the National Best Bid and Offer (NBBO) and with the “best execution”.   

This has the potential to create a conflict of interest, as some exchanges utilize different pricing incentives to brokers to not only look for the best price at the NBBO, but also to trade where the rebates are greatest to them. 

Implications to Traders and Investors

When the typical American consumer places their retail trades from home in the evening, they may stipulate that they’d be willing to pay up to $20.10 for a share of XYZ Stock.  The firm buying these orders can see what they want, and they can see that the NBBO is at $20.09 x $20.10.  This is where they can pass the order onto the public markets and buy the $20.09 offer, or it’s more likely that they will sell the stock to the customer from their own reserves at $20.0999, to give the appearance of improving the execution in return for jumping in front of every other offer at $20.09.  They now are just inside the bid and have the possibility of midpoint pricing in dark pools to buy it back at $20.095.

Role of Technology

In addition to this, POF firms utilize quick direct feeds to see the market milli-seconds before it is available in the NBBO.  In the above example, this means it’s possible that the market has already moved from $20.08 x $20.09.  If the NBBO is still displaying an offer of $20.10, they can give the execution at $20.10, which is the best official offered price, and immediately buy the $20.09 offer they know is coming. 

Even when the buy-sell difference is a fraction of a penny, do not be fooled, this is a multi-billion dollar industry available only to the select few.  

This practice hurts the average day trader as the POF firms process all of the uniformed retail customer orders first, leaving the informed flow as all that’s available to be absorbed and traded by the exchanges. 

Another frustration for daytraders trying to sell at their $20.10 price is that they act as nothing more than a pricing reference point for firms that see the orders first.  The trader only gets to sell at the $20.10 price if the firm seeing their order decides not to sell it themselves, which would likely mean that it is not a good trade any longer.

If you are an experienced, hard-working trader frustrated with your ability to get quality executions, Limits on Payment for Order Flow is probably high on your Wish List.  

Headquartered in Chicago, Great Point Capital, LLC, is a member of FINRA and has been serving the trading community since 2001. Our mission is to be the leader in the equity day trading community by giving the best traders the tools and support to make the most of their trading careers.  Contact Great Point Capital, LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.