Most modern retail brokerages (like Robinhood, Webull, and E*Trade) offer $0 commission trading. While this seems “free” to the user, the brokerage must still generate revenue to sustain its infrastructure. The primary mechanism for this is Payment for Order Flow (PFOF).
PFOF is the practice where a brokerage routes its customers’ trade orders to specific “market makers” or “liquidity providers” rather than directly to a stock exchange.
The Mechanical Flow of a Trade
When you hit “Buy” on a PFOF-enabled app, the following behind-the-scenes steps occur:
- Order Entry: You place an order for 10 shares of a stock.
- Routing: Instead of sending your order to the New York Stock Exchange (NYSE), the broker sends it to a wholesale market maker (such as Citadel Securities or Virtu Financial).
- Execution: The market maker fills your order. They might sell you the shares from their own inventory or find a match elsewhere.
- The Rebate: The market maker pays the brokerage a small fee (typically a fraction of a cent per share) for sending them the order.
Why do Market Makers pay for orders?
Market makers profit from the Bid-Ask Spread—the difference between the price someone is willing to pay and the price someone is willing to sell for.
- Profit Logic: By handling a massive volume of “retail” orders, market makers can capture the spread thousands of times a second. Because retail investors (individuals) are generally considered “uninformed” compared to institutional “sharks,” they are safer counterparties for the market maker.
- Data Advantage: Access to the constant stream of retail orders provides the market maker with valuable real-time data on market sentiment.
The Impact on You: Price Improvement
The core debate around PFOF is whether it helps or hurts the individual investor.
- Price Improvement: Regulators require that market makers provide a price that is at least as good as the NBBO (National Best Bid and Offer). In many cases, market makers provide “price improvement,” meaning they give you a slightly better price than you would have found on a public exchange.
- The Tradeoff: While you save $5 or $10 on a commission fee, critics argue that PFOF creates a conflict of interest, where the broker might route your order based on who pays them the most, rather than who provides the absolute best execution.
Who uses PFOF?
- PFOF-Heavy: Robinhood, Webull, E*Trade, Ally Invest.
- Direct-Exposed: Interactive Brokers (Pro) typically avoids PFOF by charging a commission and using “SmartRouting” to find the best market price. Vanguard also limits PFOF for stock trades.
- Transparents: Public.com famously moved away from PFOF, instead offering users an optional “tipping” model and routing orders directly to exchanges.
Summary
PFOF is the mechanical engine that made commission-free trading possible for the average person. While it introduces a layer of institutional complexity and potential conflicts, it has also drastically lowered the barrier to entry for the stock market by removing the flat “toll” of transaction fees.
See also: How Order Types Work, Interactive Brokers vs. Webull Comparison, Best Stock Brokers for Beginners
