Payment for Order Flow

Definition

The term payment for order flow refers to the compensation received by brokers from third parties when an order is routed to the third party for execution. Payment for order flow is one of several ways a broker is compensated when an investor places a buy or sell order.

Explanation

The duty of best execution is a requirement under the jurisdiction of the Securities and Exchange Commission (SEC). This requirement mandates a broker to seek out the most favorable terms of execution reasonably available to their clients, including securing the best possible price. Payment for order flow aligns with this duty and can be summarized into three steps:

  1. An investor contacts their broker to execute a trade; this includes both buying as well as selling a stock.
  2. The broker routes the trade to a third party, and collects a fee for providing them with the order.
  3. The third party fulfills on the obligation to find the most favorable terms for the investor.

Third parties, such as market makers and securities exchanges, will pay this fee because they are able to aggregate orders and due to the scale of their trades can buy at the bid prices and sell at offer. This allows them to capture this spread while reducing risk.

Securities and Exchange Commission regulations require brokers to inform their clients if they receive payment for order flow and detail the fees they collect in this process. When confirming a trade, the broker must also disclose whether they received payment for order flow and allow the investor to request the details of the transaction.

Related Terms

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