Regulation on Payment for Order Flow

Payment for Order Flow (POF) is the cunning practice of many third-party firms that pay brokers to send them their trade orders, many retail trades, instead of sending them to the open market.

The POF firm can then either take those orders and execute themselves, or they can pass it on to the market to fill against existing quotes.  As the typical retail investor is basically uninformed and do not see the real-time market prices, POF firms love receiving retail trade.  When they sell  to the customer they may offer a price improvement of 1/100^th of a penny, giving the appearance of a price improvement.  In reality, they may have already seen that the NBBO is moving downward, so they’ll jump in front of it and make the execution at the current higher price, then immediately buy it back at a discount.

They also may find it in a dark pool at an even greater discount.  Furthermore, firms paying for order flow are using high speed direct data cables, allowing their computer algorithms to pick up on the price change fractions of a second before its represented in the NBBO.  This speed advantage coupled with the guaranteed order flow creates a liquidity problem for daytraders, who can only trade what’s left of the POF and High Frequency Trading (HFT) firms. 

Current Regulation

When it comes to payment for order flow, disclosure is the main approach taken by the SEC.  Rule 10b-10 requires broker-dealers to reveal that a payment for order flow arrangement exists on their customer’s statement.  They are not, however, required to disclose information regarding the source or the nature of the compensation received, unless the customer submits a written request. 

It is doubtful that customers are even reading the fine print or the quarterly reports, and even more unlikely that they’ll submit a written request asking about the payment arrangement. 

Brokers are required, however, to complete the trade with the “best execution”, and at the best NBBO price.  This is what can create a conflict of interest.  Some exchanges offer different pricing models, which could be incentive to some brokers to look for the best price under the NBBO, but they may also search out the best rebate available to them. 

Rather than just require disclosure, perhaps the implications to the investor, the market and all traders should be reviewed further.  The benefit to the broker is obvious – rather than incur an expense to trade, they enjoy a robust profit center.  How does this benefit the firm paying for order flow?  The advantage of a first look at orders before displayed on the market is the clear advantage here, it’s what allows them to pay for order flow and still turn a profit.  Does this elite privilege come at a cost to the market and investors?

This particular topic has generated a lot of attention as Senator Carl Levin has called for a complete elimination of the practice.  Of course Michael Lewis and his best-seller “Flash Boys” contribute to raising awareness to this and various other questionable Wall Street practices. 

Most daytraders that we talk to agree with Senator Carl Levin and Michael Lewis in that Limits on Payment for Order Flow are long overdue!

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.