Payment for Order Flow (PFOF) Definition

In a particular payment for order flow scenario, a broker is receiving fees from a third party, at times without a client’s knowledge. This naturally invites conflicts of interest and subsequent criticism of this practice. Today, the SEC requires brokers to disclose their policies surrounding this practice, and publish reports that disclose their financial relationships with market makers, as mandated in 2005’s Regulation NMS.

The cost savings from payment for order flow arrangements shouldn’t be overlooked. Smaller brokerage firms, which can’t handle thousands of orders, can benefit from routing orders through market makers and receiving compensation. This allows them to send off their orders to another firm to be bundled with other orders to be executed and can help brokerage firms keep their costs low. The market maker or exchange benefits from the additional share volume it handles, so it compensates brokerage firms for directing traffic.

With the industry-wide changes in brokers’ commission structures, offering no-commission equity (stock and exchange-traded fund) orders, payment for order flow has become a major source of revenue. For the retail investor, though, the problem with payment for order flow is that the brokerage might be routing orders to a particular market maker for their own benefit, and not in the investor’s best interest. 

investopedia Payment for Order Flow (PFOF) Definition