What is PFOF?
Payment-for-order-flow (PFOF) is a market mechanism where brokerages route their customers' orders to market makers and in return for routing orders, brokerages receive payments and best-execution service from market makers. Currently, PFOF does not exist in digital markets but has existed in traditional US equity and options markets. For context, in the US, PFOF is around a $3.6 billion market and around 70% of Robinhood's annual revenue (e.g. $1.8 billion in 2021) comes from PFOF.
The parties involved in a PFOF arrangement are brokerages, market makers, and retail investors.
- Brokerages are consumer facing applications that route orders for their customers (i.e. retail investors) – they may either route to a public exchange or directly to market makers (i.e. PFOF)
- Market makers provide liquidity to markets by buying when the other side wants to sell and selling when the other side wants to buy and are compensated the bid-ask spread for taking the risk
- Retail investors trade on brokerages and generally in smaller sizes and with less information than institutional investors
A PFOF model aligns the incentives for all three participating parties.
- PFOF enabled brokerages to monetize their order flow. Historically, brokerages charged fixed commission fees per trade which acted as a barrier to entry for retail investors who tend to trade small sizes. Payments from market makers created a new business model for brokerages and allowed them to pass on benefits like zero fee trading and price improvements to their customers.
- PFOF created a new business for market makers. Traditionally, market makers made markets on public exchanges so a venue for executing only customer orders opened up a new opportunity. When filling customer orders, market makers typically face less adverse selection risk. However, they had to compete on price improvement metrics (i.e. filling orders at tighter spreads than what's available publicly).
- PFOF allowed retail investors to get better prices. Retail order flow is inherently valuable to market makers and through PFOF, individuals are realizing this value in the forms of zero fee trading and price and size improvements, which are real cost savings.
Much of the public scrutiny over PFOF is from a misunderstanding of the underlying mechanism. There are many great resources like this and this that go in-depth on the intuition behind PFOF. However, a core criticism of traditional PFOF is the lack of transparency behind order handling and execution, where statistics are not easily viewable and verifiable. This, along with the general distrust of traditional financial institutions, contribute to a lot of the negative press surrounding PFOF.
DFlow PFOF: Open and Fair
DFlow reintroduces the PFOF model by bringing transparency and fairness to the PFOF model seen in the traditional markets. Traditionally, order flow is sold using long-term contracts with opaque terms between brokerages and market makers.
On DFlow, any order flow source can create and run auctions and any market maker can bid and fill order flow from the auctions. Decentralizing the process of order flow distribution prevents private or exclusive order flow.
Why is private order flow bad? Worse prices and monetization for users and wallets, respectively. In uncompetitive and inefficient markets, the sole market maker has no incentive to price the order flow fairly (i.e. it will under pay the fair amount).
In replacement of opaque terms found in traditional PFOF, DFlow standardizes order flow auction design and specs. In addition, created auctions are viewable by anyone in the public. Standardization of auctions ensures clear commitments and terms between parties. The seller knows exactly what it’s selling, and the buyer knows exactly what it’s buying, since in traditional markets there is a lack of clarity how order flow is being sold and purchased.