Why understanding payment for order flow is important if you trade and invest

SINCE 2020, we have seen an acceleration of a global trend expedited by the pandemic, of more people taking greater control over their savings and investments. This greater participation and empowerment of retail investors will remain a dominant market force for the foreseeable future.

As more people now access the capital markets, it is more important than ever that investors are given better access to company and trading data, to improve their access to funding and broaden their investment opportunities.

Most recently, the European Commission has taken steps to follow the Australian Securities and Investments Commission's position in banning the practice of payment for order flow (PFOF), to circumvent the emergence of PFOF arrangements. This is a critical move that will level the playing field for investors and bring more transparency, so that clients know they are not selling their flow to market makers.

But what is PFOF, and why is it important for retail investors to be sure their brokers are not practising it?

PFOF is the compensation a brokerage firm receives for directing orders to a particular venue for trade execution. The brokerage firm receives payment, usually fractions of a penny per share, as compensation for routing the order to a specific market maker.

PFOF is a method of transferring some of the profit from market making to the brokers that route customer orders to the market maker. In this manner, the broker generates an additional source of income, while the market maker ensures retail volume is being routed their way, which in return simplifies their practice of market making (matching buy and sell orders) and ultimately leads to higher profits for the market maker as well.

The most common criticism of PFOF is the fact that a broker is receiving fees from a third party without a client's knowledge. Such payments incentivise the broker to route its orders to a particular venue, which naturally could be considered a conflict of interest. The broker may choose to send the order to the venue offering the highest payment to the broker rather than the best execution to the client.

Conflict of interest

Moreover, as this process has become so widespread that it is reducing liquidity and likely influencing prices at exchanges - with orders executed elsewhere - it has proved controversial, and is receiving attention from regulators around the world.

For many low-cost brokers offering zero or low commissions on equity transactions, PFOF is a major source of revenue. This practice could cause a conflict of interest between broker and client as the brokerage firm might be tempted to route orders to a particular market maker for their own benefit, rather than seeking a best execution price for the investor, their client.

Further, many of the market makers to whom order flow is sold are hedge funds. As such, they are in a position to use the information in the flow to inform their own algorithmic trading decisions, and to trade with very high frequency in the market, much more so than any retail investor ever could. Investors are often unaware that their orders are sold to hedge funds, and of the impact this can have.

Investors who trade infrequently or in small quantities may not feel the impact from this practice. However, frequent traders and those trading large volumes should aim to understand their broker's order routing system to make sure that they are not losing out on price improvement due to their broker prioritising PFOF.

At Saxo, we do not use or receive PFOF. Saxo executes equity orders using smart order routing (SOR) technology, which sources liquidity from multiple venues, including regulated exchanges and multilateral trading facilities, to optimise execution rates and fill ratios. SOR is an algorithm which automatically compares execution prices for any given buy or sell order. It avoids conflicts of interest by discovering best available prices and routing your orders to the venue offering best execution independent of PFOF.

In short, we source the best price available for the client, and we are not distracted by which hedge fund we can sell our clients' orders to.

As more people participate in global capital markets, brokers have a real duty of care to their clients, and we believe that it is time for regulators in Asia and the brokerage industry to review such practices and collectively work towards protecting the interests of retail clients.

• The writer is Asia-Pacific CEO of Saxo Markets.