What is ‘payments for order flow’ and how does it work?
Payments for order flow help zero-commission trading brokers to make money. Read on to find out more about this practice and how it works.
What is payments for order flow (PFOF)?
Payments for order flow (PFOF) is a practice where a broker receives compensation for directing client orders to off-exchange third parties, who then execute clients’ buy and sell orders. Though brokers benefit from sending more traffic to the third party, it is often at the expense of the client – whose trades could be filled at a worse level, or not at all.
Many traders and investors are unaware that this is happening, which is why PFOF has earned a negative reputation. PFOF is even banned in UK and Europe, but it is legal in the US – as long as PFOF agreements are disclosed and updated every quarter. Certain American brokerage companies – such as Robinhood – generate a big portion of their income from payments for order flow.
High frequency trading firms and order flow
High frequency trading firms (HFT firms) are the third parties involved in order flow. They use advanced computers and algorithms to execute buy and sell orders faster than any other business, which makes the market more liquid.
Exchanges, market makers, institutions and wholesalers are all considered high frequency trading firms – and the biggest players in the US are Citadel LLC, Tradebot, Virtu Financial, IMC and Tower Research Capital.
There are certain regulations in place that prevent HFT firms from filling an order at a very poor price; they must deal at what is known as NBBO (national best bid and offer) or better. However, they manage to make a profit by taking advantage of one of three PFOF methods:
- Retail order bundling, which is when orders from many different clients are packaged as one order
- Market making, which is when HFT firms attempt to make the spread as many times as possible by offering liquidity on both sides of the buy and sell price
- Latency arbitrage, which involves using technology to quickly acquire better prices
How does payment for order flow affect best execution?
Payment flow hinders best execution, as brokers will direct trades to the venue that hands out the biggest incentive for doing so, regardless of whether it offers the client the best price. The only sure way to avoid payments for order flow is to choose a trading broker that does not employ this practice. Alternatively, you can use a broker that offers direct market access (DMA).
IG does not accept payments for order flow – we aim to offer you the best prices and the tightest spreads by sourcing our underlying prices from multiple venues. We’ll always try to add reliable liquidity venues – reviewing them regularly to ensure we keep offering the best prices – and reduce our transactional charges. As the world’s No. 1 spread betting and CFD provider,1 we can generally offer greater liquidity and better prices than our competitors – sometimes even beating what’s available in the underlying market. Below is a simplified version of our order flow.
Direct market access (DMA)
Direct market access (DMA) is a way of placing trades directly onto the order books of exchanges. It offers greater visibility of the market, while our L2 Dealer technology aggregates prices from multiple exchanges. Because you’re bypassing any aggregation of over-the-counter (OTC) orders, you can choose the price you want to deal at.
DMA is usually recommended for advanced traders only – due to the complexities involved.
With us, you can get DMA in two ways: via CFD trading on shares and forex, and share dealing.
Read more about our DMA offering
Payments for order flow summed up
- Payments for order flow (PFOF) enable a broker to receive compensation for directing client orders to off-exchange third parties – usually high frequency trading (HFT) firms
- PFOF are often at the expense of the client, whose trades could be filled at a worse level, or not at all
- HFT firms use advanced computers and algorithms to execute buy and sell orders
- They make a profit by taking advantage of retail order bundling, market making and latency arbitrage
- Payments for order flow are banned in UK and Europe, but it is legal in the US
- The best way to avoid payments for order flow is to choose a trading broker that does not employ this practice or one that offers direct market access
Footnotes:
1 Based on revenue (published financial statements, 2022)
2 Based on IG Group's OTC data for June 2020
This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.
Discover how to trade the markets
Explore the range of markets you can trade – and learn how they work – with IG Academy's free ’introducing the financial markets’ course.
