Payment for Order Flow

Professionals Pay to Make Trades for Small Investors

By | Updated May 20, 2016 5:17 AM UTC

A U.S. retail investor sends out an order to buy or sell a stock through a brokerage account. She may think her trade heads directly to the New York Stock Exchange, but that’s rarely true. Instead, electronic wholesale firms often end up carrying out those requests. In most cases, the firms pay retail brokers for the right to execute these customer trades in a widespread practice known as “payment for order flow.” It’s a system credited with lowering trading costs for mom-and-pop investors — but regulators wonder whether it’s ultimately in their best interest.

The Situation

Two firms dominate the arena of carrying out retail trades: Citadel Securities and KCG. The U.S. Justice Department and New York Attorney General are looking into whether customers are getting the best prices for trades the firms carry out within their own systems. The Securities and Exchange Commission has also asked a committee of advisers whether the broker payment system should be banned or changed. So far the SEC hasn’t taken any steps to change the practice. Wholesalers handled about 17.4 percent of U.S. stock market trading in the fourth quarter of 2015, according to data from research firm Tabb Group.

Source: Bloomberg

The Background

Payments for order flow stretch back to the 1980s. Bernie Madoff (yes, that Bernie Madoff) was a pioneer in the field, paying firms like Charles Schwab and Fidelity a penny or two per share for the right to make their trades. Madoff’s firm could afford this back then because the New York Stock Exchange required a minimum markup of one-eighth of a dollar (12.5 cents) per share. Retail brokerages used the money collected from Madoff to lower the fees they charged clients. The end of fractions on the exchange allowed markup prices to fall, and the advent of electronic trading and regulatory changes helped the system spread. The largest wholesalers now pay just fractions of a penny for the right to trade a share and earn just fractions of a penny on the trade spread. These fractions add up — retail brokers can rake in tens or hundreds of millions of dollars from the payments annually. Wholesalers like to bundle orders from retail customers because they’re less likely to be super knowledgeable about the direction of the market than the big investment firms, thus reducing the chances that the wholesalers will lose money in the time they might hold the securities. Over the years, U.S. stock trading has shifted from the hands of big banks to leaner automated trading firms. Citadel agreed to purchase Citigroup’s Automated Trading Desk in May, adding to its market-making muscle.

The Argument

Retail brokers and trading firms say that the payment for order flow system is a win for retail customers, who have never been able to trade more cheaply. They argue that the payments help keep broker fees lower than they’d otherwise be. And they note the payouts are no secret: Any brokers that accept payments from trading firms must publicly disclose both how much they receive and how well customer trades were handled. Critics of the system argue that it sets up a conflict of interest, and that brokers may be tempted to funnel orders to the firms that dangle the most cash for their customer orders instead of firms that regularly trade for the best price. The U.K. cited this conflict of interest when it tightened regulations on payment for order flow in 2012. Among the harshest U.S. critics of the practice are former Senator Carl Levin, who called for an outright ban on the trading incentives, and Michael Lewis, who questioned the practice in his 2014 book “Flash Boys.” Under SEC rules, traders aren’t obliged to get the best price for clients, they’re obliged to get the “best execution,” which could include other factors like the speed of the trade. The Justice Department investigation is looking at whether the wholesalers are using different data reporting feeds to show that they are meeting the trade requirements.

Reference Shelf

  • The Securities and Exchange Commission’s memo to its advisory committee on market structure.
  • Bloomberg article on Senator Carl Levin’s 2014 letter calling for an end to stock market pricing models that create conflicts of interest for brokers.
  • Michael Lewis’s 2014 book “Flash Boys” called payments to brokers a “wacky incentive.”
  • CNN Money interviewed Bernie Madoff about payment for order flow in 2000, nine years before he pled guilty to running the largest Ponzi scheme in U.S. history.

First published May 20, 2016

To contact the writer of this QuickTake:
Annie Massa in New York at

To contact the editor responsible for this QuickTake:
Anne Cronin at