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Payment For Order Flow
Payment-for-order-flow (PFOF) refers to market makers paying brokerage firms for their retail order flow. In other words, sources of retail volume monetize their orders and they can do so because of the inherent value in retail order flow.
This is a win-win situation for all participants because:
  1. 1.
    Retail traders receive fills at better prices. Market makers can fill orders at better prices than on exchanges because they know they're filling retail order flow. In fact, market makers compete with each other to deliver the most price improvement to win contracts with leading retail brokerages.
  2. 2.
    Brokerage firms generate revenue from market makers who pay for order flow generated on their platforms. Exchanges, on the other hand, don't pay brokerage firms for their order flow.
  3. 3.
    Market makers do not have to worry about prices moving against them immediately after filling orders. As a result, they can fill retail orders at tighter spread and still earn the bid-ask spread over time.
In traditional markets, PFOF has been criticized for lack of transparency behind order execution and arrangements between brokerages and market makers. The problem is they are not measurable or verifiable by anyone.
Articles here and here go in-depth on the intuition and mechanics of PFOF.
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