This past week (June 23, 2021), FINRA (the Financial Industry Regulatory Authority) issued its Regulatory Notice 21-23 entitled “FINRA Reminds Member Firms of Requirements Concerning Best Execution and Payment for Order Flow” which was pointed at, one suspects, some of the recent “free” brokerage services such as Robinhood . In this blog post, we will discuss what Payment for Order Flow (PFOF) is, explain how it has enabled “free” brokerage services such as Robinhood, highlight its (speculated or actual) role in the Gamestop stock fiasco, discuss the Duty of Best Execution, and outline some of the high points of the Finra 21-23 Regulatory Notice. Summary (TL;DR) In the case of “free” and some discount stockbrokers, PFOF has effectively replaced brokerage fees, with higher prices being charged to investors on trades as a result of investors getting marginally worse prices for their orders. In other words, that “free” or discount broker isn’t as free as you think – you’re paying for it with worse pricing on your executed orders. As a result of having its bills paid by someone other than the investors, a broker may have “split loyalties” (or, at least, the potential and/or appearance of “split loyalties”) and an economic incentive that cuts against its duty to get investors the best price reasonably available (aka the Duty of Best Execution) – although acting on this economic incentive is not supposed to be legal. There is one narrative that this “split loyalty” was responsible for, or deeply involved in, some of the brokers’ actions during the Gamestop short squeeze that drew public outcry and congressional scrutiny. Specifically, that perhaps a broker who was paying Robinhood large sums through PFOF asked or requested Robinhood to freeze buy orders of Gamestop stock, while allowing sell orders. This type of market manipulation, if it occurred, would be extremely illegal. FINRA has noticed the situation and has issued a press release “reminding” firms of their Duty of Best Execution. 1. What Is Payment For Order Flow? So, Payment For Order Flow (PFOF) is exactly what it sounds like – a payment or compensation given to a brokerage for directing its order flow to a particular market maker for execution. Usually the PFOF is a rather small margin – fractions of a penny per share. But why do market makers want order flow? For a market maker, the key to making money is to be on “both sides” of as many trades as possible. So, there is one relatively innocuous explanation for PFOF – it enables market makers to increase their total number of trades, and increase the amount of money they’re making. Fun Fact: PFOF was originally pioneered by Bernard “Bernie” Madoff, although that isn’t what he’s famous for! (he’s famous for operating the largest Ponzi scheme in history, over $60B) But even in the early days of PFOF, traders using PFOF trading platforms began to notice that the prices they were receiving for their trades were slightly worse than the market price (buy orders were executed a bit higher, sell orders were executed a bit lower). Here’s one way that something like that might work:
  • PFOF broker routes order to market maker X;
  • Market maker X aggregates a block of orders and determines whether it’s a net buy or a net sell;
  • before executing the net buy or net sell, market maker X informs its proprietary trading arm to play the other side of this trade; [note that this part is illegal; there is supposed to be a “firewall” between a financial group’s proprietary trading arm and its market maker arm]
  • If the order is a net buy, the proprietary trading arm sells at a favorable price, before the PFOF order block is executed; if the order is a net sell, it buys at a favorable price, before the PFOF order block is executed; [note: this should also be impossible because the previous step is illegal]
  • as a result, the proprietary trading arm continually manages to capture a small margin on each of these trades, aggregating huge profits. [should likewise be impossible]
Doesn’t seem quite fair, does it? Or, here’s another way it might work:
  • PFOF broker routes order to market maker X;
  • Market maker X aggregates a block of orders;
  • It turns out that, the buy price charged to the buy orders in the block, and the sell prices returned to the sell orders in the block, come in just a little bit further apart than the spread at the market based on the NBBO, or National Best Bid or Offer – maybe by a few cents per share – but because the stock price is moving around by at least that much, nobody really notices;
  • the market maker, meanwhile, pockets a large profit based on this spread.
Also seems unfair, right? After this practice emerged, and there were allegations that investors were getting prices worse than the NBBO, the SEC (US Securities and Exchange Commission) came in and examined the issue, focusing mainly on PFOF in the context of options (although PFOF is used for many different types of securities), and very nearly concluding that the practice should be outlawed entirely:
While the fierce competition brought on by increased multiple-listing produced immediate economic benefits to investors in the form of narrower quotes and effective spreads, by some measures these improvements have been muted with the spread of payment for order flow and internalization
In essence, the SEC concluded that, although it didn’t like PFOF and there was a significant potential for abuse of PFOF, the pro-competitive (potential) results of PFOF outweighed the potential for abuse. In addition, at least for the time being, the SEC focused on PFOF with regard to options. Since that evaluation, the SEC has continued to watch PFOF closely, although the practice remains legal. Brokers are also required to provide reports under Rule 605 and Rule 606 which detail execution quality and PFOF statistics. While these reports can be difficult to find at some brokerages and typically “do not provide the level of information that allows a retail investor to gauge how well a broker-dealer typically fills a retail order when compared to the ‘national best bid or offer’ ” they are nonetheless a required disclosure and may be useful to investors when evaluating or comparing brokerages. 2. How Does Payment For Order Flow Enable “Free” Brokerage Services Like Robinhood? Historically, a stockbroker would charge commission to investors in order to complete a trade. This commission would cover everything from the salaries of the brokers themselves and software involved in that actual trade to the overhead of the brokerage like rent, lights, and coffee. Eventually, different brokerages began to compete on price. But then, some enterprising brokers began to offer “commission-free” trading. How is this possible? Obviously, stockbrokers do not work for free, nor is rent or coffee free. So how can a company or an app offer stock trading for free? Simple. They fund operations with PFOF. So, rather than the commissions from the investors funding the operations of the broker, payments from the market maker fund the operations of the broker. As noted above, however, investors with those brokerages began to notice that they were receiving less than optimal pricing for such orders, and the SEC began to examine the practice – ultimately taking a dim view of the practice but concluding that it was legal (if only barely). To illustrate the problem here, a question: who is the client? who is the broker serving? The answer should be “of couse, the client is the investor” – but if the investor is not the person paying the bills, is that really the answer? After all if the tech industry privacy scandals, haven’t we learned that “if you’re not paying for the product, you are the product” rings true? Let that group of questions sit for just a moment while we examine the role (actual or alleged) of PFOF in the Gamestop disaster that I wrote about earlier. 3. What Was The (Alleged) Role of Payment For Order Flow In The Gamestop Clusterf**k? Robinhood, one of the “free” brokerages formerly beloved by reddit’s wallstreetbets community, was at the heart of the Gamestop stock frenzy and subsequent mess. Robinhood funded its operations through PFOF, and accordingly was able to offer stock trading services “free” to its users/investors. Let’s start with what went especially wrong during the Gamestop fiasco. When the price of Gamestop was racing up (due to an incipient short squeeze and perhaps other factors), Robinhood (and some other brokers) stopped accepting Buy orders for Gamestop stock, but was accepting Sell orders for the same stock. This is a big deal, especially in light of the Duty of Best Execution, which we will discuss in more detail below. There are two potential explanations:

(1) If this freeze on Buy orders was due to prevailing market conditions, capital requirements, etc., then it’s not such a scandal. It’s just a broker staying within its regulatory sandbox, and following the rules that it has been given.

(2) If, on the other hand, this freeze on Buy orders was due to a cozy relationship that Robinhood had with a third party, it would be all kinds of illegal market manipulation and present a gigantic problem.

The first explanation isn’t so interesting. Let’s talk about the second explanation. One particular market maker, Citadel Securities, was particularly profitable for Robinhood. Citadel Securities, which sits under the same affiliated-company group as Citadel LLC (its parent which operates a proprietary trading arm, which – recall from above – is supposed to be “firewalled”) is a massive market maker for the US securities markets, capturing over 10% of all trading volume in the US. It is estimated that Robinhood accounted for 40% of Citadel’s trading volume (and, presumably, Citadel accounted for a large percentage of the counterflowing PFOF – although greater or less than 40%, who can say?). A sizeable incentive, to be sure. The plot, however, continues to thicken. Citadel LLC (the parent entity) has a short position in GameStop, and is invested with some other hedge funds that also have short positions in GameStop (including the now-infamous Melvin Capital). Following this, some reddit/wallstreetbets users notice that the short position is quite large, and a short squeeze happens (whether it happened naturally or was coordinated can be discussed another time – but it happened). Gamestop rises from $4 per share to at one point over $300 per share (as of the writing of this article, the price is around $190 per share). When you’re short a stock, you have to pay interest to whoever you borrowed the stock from, as a percentage of value. So, the interest due in respect of short Gamestop shares rose by almost 100x. As did the cost to close out of the trade, go home, and lick your wounds. As part of this, Citadel LLC invests $2.75B into Melvin capital, largely to cover the GameStop losses. Reuters has estimated that Melvin lost half of the value of the entire fund in Q1. And while we can’t be certain that was all the Gamestop trade… what else could it be? Citadel and its affiliates stand with a massive loss from the whole fiasco, and is staring at the potential of it getting worse, as the short squeeze continues. At this point, Robinhood begins limiting its users ability to buy shares of GameStop (but not to sell), citing Can you see how this starts to look suspicious? A public outcry ensues, including congressional hearings and a delay of Robinhood’s vaunted IPO and all kinds of different folks accusing Robinhood, Citadel, and Melvin of market manipulation or worse. Many of reddit’s wallstreetbets users begin to leave Robinhood for other platforms that will let them buy shares of Gamestop, and many articles are written. Congress, by the way, ultimately does nothing (surprise!) But as I said above, PFOF is legal. The SEC has looked at it. So what’s the problem? To answer this question, I will discuss the Duty of Best Execution and consider what FINRA has to say about the PFOF-funded “free” brokers. 4. What is the Duty of Best Execution? The Duty of Best Execution is a duty that applies to brokers. A Broker is “legally required to seek the best execution reasonably available for their customers’ orders” (SEC definition). Or, according to FINRA, “essentially obligates a broker-dealer to exercise reasonable care to execute a customer’s order in a way to obtain the most advantageous terms for the customer.” What does this actually mean? Well, the best execution means something like the best price and the best speed. But the “reasonably available” and “reasonable care” modifiers here – as any lawyer can tell you – signals some discretion and “wiggle room” here. It means something like, the best price and speed that can be found considering the various circumstances, etc. A broker is supposed to consider factors such as the likelihood that a better price than the currently-quoted price can be obtained (this is often referred to as “price improvement”), the speed of execution, and the likelihood that the trade will be executed (at all). In light of these factors, and other pravailing market conditions, the broker is supposed to get the best execution for a customer’s order that it reasonably can get. It is a very fact-dependant determination. In discussing the Duty of Best Execution, FINRA notes that “as the circumstances of each order and trading environment vary, so does the determination of what is best execution.” While above, much has been discussed about market makers, these are not the only options that broker-dealers have for executing a customer’s order (and the Duty of Best Execution applies to all of them):
  • The actual stock or equities exchange(s)
  • A market maker
  • An Electronic Communications Network (ECN)
  • The firm may “internalize” the order
Additionally, this is not, as the SEC has explained, merely a statutory or regulatory duty. A broker-dealer is a fiduciary and it bears the full responsibilities and all trappings that accompany that fiduciary relationship arising from the common law of agency. In sum, when FINRA describes the Duty of Best Execution as “a significant investor protection requirement,” this is not an exaggeration. Both FINRA and the SEC have published a significant amount of guidance on this topic, and the recent market turmoil surrounding Gamestop has triggered a reminder from FINRA. 5. So, What’s The Deal With This FINRA 21-23 Notice? FINRA issued this notice to “remind” firms that PFOF should not interfere with their Duty of Best Execution. And, of course, if it weren’t interfering (or potentially interfering, or appearing to interfere…), there would be no real reason to issue this kind of “reminder”. Whether this “reminder” rises to the level of hinting that FINRA member firms are engaging in market manipulation is an open question (read the Notice for yourself and decide!)
FINRA is issuing this Notice to remind member firms of longstanding Securities and Exchange Commission (SEC) and FINRA rules and guidance concerning best execution and payment for order flow, which the SEC has defined very broadly to refer to a wide range of practices including monetary payments and discounts, rebates, or other fee reductions or credits. Under these rules and guidance, member firms may not let payment for order flow interfere with their duty of best execution.
So let’s break down what FINRA is saying here. First, FINRA discusses the Duty of Best Execution in general, including a review of the following factors that may be used in determining/evaluating whether the firm has used “reasonable diligence” to obtain best execution:
1. the character of the market for the security (e.g., price, volatility, relative liquidity, pressure on available communications);
2. the size and type of the transaction;
3. the number of markets checked;
4. accessibility of the quotation; and
5. the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.
As noted above when we discussed the Duty of Best Execution, there ends up being a good amount of wiggle room, not only because some of these factors are inherently subject to uncertainty, but also because these factors may not always all point in the same direction. Nonetheless, these are useful “signposts” for a broker-dealer or other firm to consider. FINRA goes on to list 8 separate quality review factors ((1) price improvement opportunities (i.e., the difference between the execution price and the best quotes prevailing at the time the order is received by the market); (2) differences in price disimprovement (i.e., situations in which a customer receives a worse price at execution than the best quotes prevailing at the time the order is received by the market);19 (3) the likelihood of execution of limit orders; (4) the speed of execution; (5) the size of execution; (6) transaction costs; (7) customer needs and expectations; and (8) the existence of internalization or payment for order flow arrangements.) that have been previously discussed in FINRA Notice 15-46, noting that it would be a violation of the Duty of Best Execution if the broker-dealer does not consider and compare the execution quality they receive under existing order routing compared to the quality they could get from other arrangements – in other words, FINRA is instructing broker-dealers that the Duty of Best Execution includes a duty to “comparison shop”. What’s more, this “comparison shopping” quality calculation may not include or refer to the PFOF payments! Also of critical importance, FINRA reminds us that the Duty of Best Execution is not transferable to another person or entity, and that (under SEC guidance) PFOF must not interfere with the broker’s Duty of Best Execution. The broker-dealer who takes the customer’s order is “stuck” with the duty. As a result, a firm that passes its order flow to a market maker or ECN that is known to provide poor execution with regard to price, time, etc. may, by sending that order flow, be in violation of the broker-dealer’s Duty of Best Execution. Lastly, FINRA notes that the disclosures required of broker-dealers under SEC Rule 606 (which requires quarterly public reports showing to which venues the broker-dealers routed their order flow, as well as PFOF statistics for that flow) do not function as a cure for any potential Duty of Best Execution violations. Let’s take one more “pit stop” and state the obvious, or the should-be-obvious. If the theory (discussed above) that Robinhood halted Gamestop buying because of a request from Citadel turns out to be true, this would be a flagrant violation of Robinhood’s Duty of Best Execution. Stay tuned on that question, as FINRA and the SEC continue to sniff around. FINRA concludes its Notice 21-23 on a note that will, I suspect, sound ominous for the “free” brokers:
FINRA recently expressed its support for the [SEC]’s efforts to consider whether additional best execution requirements or guidance are needed to promote investor protection, and FINRA may evaluate whether further changes to its best execution rule are necessary or appropriate
In other words – FINRA believes that PFOF is probably inconsistent with the Duty of Best Execution. FINRA has accordingly asked the SEC to initiate rulemaking, and if the SEC doesn’t then FINRA might. Buckle up, folks. It’s going to be an interesting ride. 6. Bonus Round: But Does MY Brokerage Take This Worrisome PFOF Money? It is a tough question to answer. But let me refer you to two sayings, one a little older, one a little newer:

If you’re not paying for the product, you are the product

and

There ain’t no such thing as a free lunch

In other words, there’s not a broker in the world that offers truly free stock trading. If you think you’re not paying a commission, it’s just being priced into the trade some other, different, hidden, and possibly much worse, kind of way – you are definitely paying a commission, one way or the other. Here’s a chart comparing the PFOF for Q1/Q2 of 2020, prepared by Richard Repetto of Piper Sandler, a NYC investment bank. As you can see, it compares the PFOF from TD Ameritrade, E*TRADE, Charles Schwab, and Robinhood. According to Repetto, with regard to Option PFOF, Schwab receives the lowest rates while TD Ameritrade and Robinhood receives the highest. With regard to Equity PFOF, Robinhood received the highest rates (while the rest of the industry discloses its trading statistics using the same metrics, Robinhood refuses to do so).   You can also watch this YouTube video on the topic of FINRA, the Duty of Best Execution, Robinhood, Gamestop, and the SEC: