Payment for Order Flow
This article explains the payment for order flow concept, how it works and reveals stunning statistics.
- How much money was made by brokerages?
- Who paid the most money for order flow?
- How did the business grow?
You will be thrilled by the revealed results!
The statistics of the article will be updated every quarter once all brokerages officially published the 606 disclosures. Please reach out to me if you need more information or a specific split of 606 data points.
What Is Payment for Order Flow
Payment for order flow means that venues like Citadel Securities pay money to brokerage businesses like TD Ameritrade for routing retail buy and sell orders to the venue system instead of sending it directly to the stock exchange.
Payment for order flow is typically beneficial for all parties involved.
- Back in the days, brokerages had to pay fees to stock exchanges like NYSE and Nasdaq if a trade took liquidity, and they charged commissions of typically $5 per order from clients for each trade. Today, brokers do not pay fees to the stock exchange for taking liquidity if retail orders are routed to the venue. Nearly all leading retail brokers offer zero-commission trading for stocks and options.
- Besides the benefit of paying zero commissions, now traders and investors often receive a better execution price if they are using market orders since the customer orders get mapped in the venue's system, which often leads to price improvements compared to the NBBO (national best bid and offer). In Q4 2020, TD Ameritrade stated that 96.9% of all orders improved.
- Venues also benefit from the order flow since they keep some of the profits made from matching orders within their internal systems. The spread between the bid and ask is the source of income.
Payment for Order Flow Concept
You may ask yourself why a venue does pay money to the brokerage firm if the venue does all the work. The answer lies between the bid and ask; the so-called bid ask spread.
Let's say you are interested in buying stock of company XYZ. The order book shows a national best bid of $105.50, and the best ask is $106.00. If you send a market order to buy 100 shares for the best possible price, your order would probably be executed at $106.00 (I want to keep this example simple, and things like hidden orders, market depth etc., are left aside.)
If in the next moment the best bid and ask are still at $105.50 and $106.00, and you hit the sell market button to close your position immediately, then your order would probably be executed at $105.50.
In that case, you lost 50 cents per share, which equals a total loss of $50.
If you allow your broker to take care of the order routing, they route the retail order to third party firms like Citadel Securities or Two Sigma Securities, called venues.
They receive thousands of buy and sell orders for hundreds of stock symbols every minute. An algorithm matches the client orders if possible. Since not all orders with exact the same order size arrive at the venue's system at the exact same time, proprietary algorithms average down the order flow and evaluate the potential of price improvements. The venue always has the option to route the order further to the stock exchange.
Back to our example, your buy market order for 100 shares of company XYZ arrives 10 milliseconds before another trader wants to sell 100 shares of company XYZ by using a market order. Typically you would get filled at the next best ask at $106, and he at the next best bid at $105.5. But the venue now maps both orders using their algorithms and shares the profit made.
A significant portion of the benefit of $0.50 per share goes to the retail traders by providing them with a price improvement. Let's say the buyer gets a fill at $105.8 instead of $106.00, and the seller receives a fill at $105.7 instead of $105.5. Both traders are happy, they did not pay commissions, and both got a price improvement of 20 cents.
The remaining 10 cents (the difference between $105.7 and $105.8) is the profit for the venue. But the venue shares this profit with the brokerage business, so they pay for order flow. This profit split is the Payment for Order Flow, where the venue pays the retail brokerage firms for sending liquidity to them, based on the order flow arrangements and conditions.
Now you may legitimately ask yourself how a venue or broker could make money if the most significant portion of the benefit goes to the investor via price-improvements. Until the end of 2019, you could only guess how much money was made via payments for order flow.
As of now, 22,000 people ask search engines every month "How Does Robinhood Make Money." Thanks to the SEC's revised requirements in SEC Rule 606, U.S. brokerages must list the exact paments received within the 606 disclosure every quarter since 2020. Now we can answer the question of how much money do retail brokerages make by selling order flow.
Let's have a look at the exact numbers by analyzing the 606 disclosures of the 7 leading U.S.-brokerages. I've downloaded and mapped all statements covering the whole time frame from January 2020 to December 2020.
Payment for Order Flow per Broker
In 2020, $2.6 billion were paid to the 7 retail brokerages TD Ameritrade, Robinhood, E*Trade, Charles Schwab, Webull, TradeStation and Ally Invest. TD Ameritrade and Robinhood make the most money by selling order flow to venues.
|Brokerage||Payment for Order Flow 2020|
Now let's look at the details for the two leading brokerages receiving payments for order flow from venues like Citadel Securities, Global Execution Brokers, and Virtu Americas.
TD Ameritrade Payment for Order Flow
The TD Ameritrade payment for order flow statistics reveals that TD Ameritrade clearly leads all brokerages with $1.15 billion PFOF (44%). Due to the merger of TD Ameritrade and Charles Schwab, a market share of >50% goes to Charles Schwab (9%)/TD Ameritrade (44%).
TD Ameritrade received the highest payment in June 2020.
Robinhood Payment for Order Flow
The Robinhood payment for order flow saw significant growth in 2020. The trading app is more popular than ever before. New mobile trading apps like Webull may take some market share, but Robinhood leads the segment of mobile trading apps and revenue for selling order flow with $0.69 billion (26%) and received the highest payment in December 2020.
Payment for Order Flow per Venue
Looking at the payment for order flow per venue statistics paints a clear picture about the market leaders. 41.6% of PFOF revenues ($1.08 bn) were paid by Citadel, followed by Global Execution Brokers 17.1% ($0.45 bn) and Virtu Americas 12.0% ($0.31 bn).
|Global Execution Brokers||$445,993,659|
|G1 Execution Services||$194,878,861|
|Dash Financial Technologies||$105,430,694|
|Two Sigma Securities||$63,308,651|
You can also see that various venues are specialized in one or the other asset sector. Venues like Citadel pay for order flow in all three categories, from S&P 500 stocks to NON-S&P 500 stocks and options. Global Execution Brokers and Dash Financial Technologies are specialized in options, while Virtu Americas focuses on stocks.
Payment for Order Flow by Month
In 2020, we saw significant growth in order flow payments, mainly affected by the global challenges. With more people working from home, and higher demand to make money trading the stock market because of zero interests, the online trading industry sees news highs quarter by quarter. Another reason for the growth is the zero commission. That's an interesting situation. Zero commissions boost payment for order flow revenues since retail investors trade more because it is free to trade.
In January 2020, the payment for order flow was $116.3 million. In June 2020, we saw a temporary high at $293.6 million. 2020 ended with a record breaking payment for order flow of $295.4 million in December.
The split by broker reveals that most brokers saw the lowest PFOF compensation in October after the highs in June 2020. The mobile app focused brokerages Robinhood and Webull showed the most substantial gains between October and December 2020, with +60% for Robinhood and +47% for Webull.
Payment for Order Flow by Asset Category
The categories NON-S&P500 stocks and options orders dominate the payment for order flow revenues. It is not a surprise since the spread, which is the baseline for the income, for S&P500 stocks is small and the liquidity immense. Therefore it is hard to generate price improvements for clients or meaningful income to be shared between venues and brokers.
The payment for order flow is dominated by the options trading category with $1.53 bn of $2.6 bn, which equals 58.9%. The ratio is similar across all brokerages.
This trend might have been one reason for Webull to offer commission-free trading for options with zero fees per contract. Other brokerages also offer zero commissions for options trading, but they charge about $0.65 fees per contract.
Some brokerages used different company descriptions within the brokerage 606 disclosures, and some also have different company divisions where the payments for order flow are allocated. Here is my brokerage mapping:
The list of venues is long, and in some cases, they are also differently mentioned within the brokerage 606 disclosures. Therefore, I mapped the venues and also focused on the key players. Here is my venue mapping:
January 2021 was a month that we would remember for a long time. Robinhood, Wallstreetbets, Hedge Funds, Citron Research, GameStop, AMC Entertainment, Nokia, BlackBerry dominated the street news.
The Reddit forum r/wallstreetbets grew from 1.8 million members on January 1, 2021, to 7.6 million on January 31. The Robinhood app downloads skyrocketed to new highs, some of the mentioned company stocks explode with temporary gains of over +1,000% and fell 90% after that.
One can only guess right now how this media presence affected the payment for order flow revenue. The minimum growth in January 2021 should be +10%, and in the next months, that may consolidate.
A controversial discussion began if payment for order flow is beneficial, transparent, and fair. We may see some regulatory changes in the future.
If brokers are not allowed to receive payments for order flow anymore, a major source of income for them will disappear. Then, the chances are that commissions per trade have to be re-introduced.
Official statistics clearly show that most client orders see price improvements if the orders are routed to the venues. Therefore there is no clear right or wrong.
Selling order flow has become one of the primary sources of income for U.S. Brokers. TD Ameritrade and Robinhood dominate the market for this income channel with $1.8 billion of $2.6 billion payments received for order flow in 2020.
Charles Schwab bought TD Ameritrade for $26 billion, and Morgan Stanley acquired E*Trade for $13 billion. We may also see further consolidation activities in the brokerage sector. Depending on how the mergers are executed and which entities remain, the market share per brokerage may change 2021 and beyond.
The quarterly 606 disclosures are the first step in the right direction. The current media presence shows that even more transparency would be beneficial to the industry.
How Do I Know if My Broker Receives Payment for Order Flow
You can check the public 606 disclosure of your broker to see if they receive payments for order flow. Unfortunately, it is not that easy to find the statements on a brokerage website. Use your favorite search engine to look for your brokerage name and add 606 disclosure to find it faster.
Alternatively, you can see it like this: If you are in control of the order routing, then your broker probably does not receive any PFOF. But if you are using order routing methods like "smart" or "intelligent," then your broker probably routes the order to one of the venues and receives PFOF.
The U.S. Securities and Exchange Commission Rule 606 requires U.S. registered brokers to publish a "Public Order Routing Report Under Rule 606". You can find further details in this SEC document at sec.gov.
Does It Make Sense to Use a Direct Access Broker Instead of a Retail Broker
A direct-access broker specializes in providing day traders with high-speed order execution and the full range of order routing options. Traders can send orders directly to the NYSE, Nasdaq or Electronic Communication Networks like ARCA.
Low-latency servers with near-stock exchange locations ensure fast order executions. Direct access brokers require traders to fund their account with a minimum of $30,000 and charge commissions of about $0.005 per share. Higher trading volume may reduce the commissions. Keep in mind that exchanges may charge or pay for placing orders on their exchange network.
Is the Concept of Payment for Order Flow New
The concept of payment for order flow is not new. Since the rise of exchange networks, all stock exchanges and ECN's try to make their network attractive to traders across the world.
The logic goes like this; if a trader removes liquidity with a market order, he needs to pay a fee. But if he provides liquidity by using a limit order, he may receive a payment if the order gets filled. The fees and payments (so-called liquidity rebates) differ from exchange to exchange.
Some order routing constellations let traders receive higher liquidity rebates than the commissions paid to the broker. Therefore, in certain situations, a direct-access broker can be cheaper and faster than a retail broker.
Would It Be Better to Have One Single Order Routing Option
If all liquidity would go to one exchange, the bid ask spreads should become much tighter. The liquidity would increase, high-frequency algorithms would be stopped from trying to make fractions of a cent by using price differences between ECN's and exchanges.
However, having only one exchange is equal to having a monopoly, which is usually not a good idea since, without competition, the fee structure might develop in an unfavorable direction for the investor.