Why payment for order flow is a good deal for investors

I don’t understand how the markets work well enough be able to wrap my head around this to be honest. But I thought I’d share it, in case anyone’s interested / can give me a TL;DR :grin: As it’s a hot topic for brokers in the US where companies like Robinhood sell order flow.

paywalled but you can read the story if you Google the title and click through from the search results

Why payment for order flow is a good deal for investors - FT

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Well, the FCA disagrees in their April 2019 PFOF report:

“ PFOF makes it more likely that extra costs will be passed on to the broker’s client, through wider bid-ask spreads from market makers and other liquidity providers who agree to pay PFOF to attract order flow from brokers. While the impact of PFOF may not be visible in bid-ask spreads for each transaction, it is likely to affect aggregate spreads as liquidity providers need to account for the payments made to brokers. These hidden costs make the price formation process less transparent and efficient. They can also distort competition by forcing liquidity providers to use a ‘pay-to-play’ model. Brokers may concentrate order flow to specific liquidity providers, while avoiding others, which may lead to poorer outcomes for clients and reduce market integrity.”

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In the world of market makers any edge on a stock is worth thousands, if not millions, of pounds they will do anything they can to get an advantage.

If you are obligated to show a bid and offer price, but you know what the future flow will be, you can influence the spread and protect your balance sheet.

You are basically buying guarantees.

Buying order flow helps large financial firms who can afford to trade off the information, the cost to an institution to place a trade is fractional to the commission they charge, you can just look at HL’s or AJ Bell’s margins in their financial reports to see this. For a company to sacrifice commissions it has to be seriously big business.

In any market being able to buy guarantees or protection and effectively price out competition is bad. What if you had an app where you could book a taxi, and they found the best company for you? Rather than charge you for this service they accepted “bids” to win your fare. The competitor with the most money could outbid everyone until they are forced out the market, or they might be the most expensive firm and give you the worst value for money.

One thing the FCA has been very good at, is focusing on levelling the playing field. RDR, PFOF, even what they tried with gold plating MiFiD II, they want to make sure everyone is transacting with the customers interest at heart.

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