Online Clock
Free stock trading apps like Robinhood and Webull have revolutionized investing and made it easier for anyone to buy and sell stocks with no commission fees... but have you ever wondered how they actually make money? The answer is called Payment for Order Flow (PFOF).
While "free" sounds great, there’s a catch. PFOF can create hidden costs for users, even if they don’t see them directly. Let’s break down how this system works and why it might be costing you more than you think. This money could be put to better use by investing in your bankroll using your bookmaker login and placing bets on your favorite teams!
What Is Payment for Order Flow?
Payment for Order Flow is a practice where trading apps sell their customers’ orders to big financial firms called market makers, companies like Citadel Securities or Virtu. These firms execute the trades instead of sending them directly to stock exchanges.
How It Works
- You place a trade – Let’s say you buy 10 shares of Apple through a free trading app.
- The app sells your order – Instead of sending your trade to the New York Stock Exchange (NYSE) or Nasdaq, the app sends it to a market maker.
- The market maker pays for the order – The app gets a small fee (often fractions of a cent per share) for directing your trade to them.
- The market maker executes the order – They fill your order, often making a tiny profit on the spread (the difference between the buy and sell price).
Why Do Companies Use PFOF?
Free trading apps rely on PFOF as a major revenue source. Instead of charging you fees, they make money by selling your orders. Market makers benefit because they can profit from the spread or trade ahead of your order (a controversial practice called front-running).
The Hidden Costs
While PFOF keeps exchanges "free," it can hurt investors in subtle ways, and here’s how:
1. Worse Prices (Slippage)
Market makers don’t always give you the best possible price. They might fill your order at a slightly worse price than what’s available on public exchanges, and over time, these small differences add up.
2. Less Transparency
When trades are carried out in the backroom, it is more difficult to understand whether you are getting a good deal or not. Bigger organizations have more information and are able to capitalize on small inefficiencies, which retail traders often fall behind.
3. Potential Conflicts of Interest
Free trading applications have an interest in directing business to the market maker who pays the most, rather than the one who will provide the best execution to you, compromising the interest of the user.
Is Payment for Order Flow Legal?
Yes, but it’s controversial. Regulators like the SEC allow PFOF but have raised concerns.
The SEC’s Stance
- Pros: PFOF enables commission-free trading, making investing accessible.
- Cons: It may lead to worse execution prices and lack of transparency.
In 2020, Robinhood paid a $65 million SEC fine for failing to properly disclose how PFOF affected customers’ trade prices.
Other Countries Ban PFOF
The UK and Canada have banned or restricted PFOF, arguing it harms investors. The EU is also considering a ban.
How to Avoid the Pitfalls
If you’re concerned about PFOF, here’s what you can do:
1. Check Your Execution Quality
Brokers must disclose execution statistics. Look for:
- Price improvement – Did you get a better price than expected?
- Fill speed – How fast was your order executed?
2. Consider Limit Orders Over Market Orders
- Market orders – Execute immediately at the best available price (but can be worse with PFOF).
- Limit orders – Set your price, preventing bad fills.