Market makers and payment for order flow

In short

You have probably placed a trade on your phone and watched it fill in under a second, and you may have wondered who was on the other side of that trade. That wonder is worth following. A market maker is a firm that agrees to buy or sell a stock at any moment, standing ready so you do not have to wait for another ordinary investor to show up. Payment for order flow is the practice where your broker receives a small payment from that market maker in exchange for sending your orders their way. It sounds simple. It changes a lot.

The whole of it

What it is

A friend of mine once bought a used wagon from a dealer who had bought it from someone else that morning. The dealer made money on the spread between what he paid and what he charged. Market makers work the same way. They post two prices at once: a bid, which is the price they will pay you, and an ask, which is the price they will sell to you. The gap between those two prices is called the spread. That spread is how market makers earn their keep. Payment for order flow, often written as PFOF, is the fee a market maker pays your broker for the right to be the one who fills your order. Your broker routes your order to that market maker instead of somewhere else. The market maker fills it and earns the spread. Part of that spread comes back to your broker as payment.

How it works

I once watched a friend play the middle at a card table, never betting big, just collecting small cuts from each hand dealt. Market makers do something similar, at enormous scale, thousands of times a day. When you tap the button to buy ten shares, your broker does not shout your order into a crowd. It sends the order electronically to a market maker the broker has a relationship with. That market maker looks at the current price on the national exchange and decides whether to fill your order slightly better than the official worst allowed price, or exactly at the best allowed price. The rule that sets the floor for how good your price must be is called the National Best Bid and Offer, or NBBO, and the SEC enforces it. Brokers are also required to seek best execution, which means they must make a reasonable effort to get you a good price, not just a legal one. The payment the broker receives is usually a fraction of a cent per share. That sounds tiny. It adds up fast at scale.

The numbers, and where to find yours

You have probably noticed that many brokers advertise zero commissions, and you may have wondered how they stay in business. PFOF is a big part of that answer. The SEC requires brokers to publish reports on where they send orders and what payments they receive. These are called Rule 606 reports, and you can ask your broker for one or find it on their website. The SEC itself explains this requirement at sec.gov. If you want to read the rule in plain form, the SEC investor education page at investor.gov is a good starting point. The exact payments vary by broker, by market maker, and by the type of security. Options orders tend to generate more PFOF than stock orders. Your broker's 606 report will show you the actual figures for your account type.

A worked example

Maria has a brokerage account with a zero commission app. She places a market order to buy 100 shares of a stock trading at 42 dollars a share. The NBBO at that moment shows a bid of 41.98 and an ask of 42.02. The spread is 4 cents. Maria's broker routes her order to a market maker that has an agreement with the broker. The market maker fills Maria's order at 42.01, which is one cent better than the ask on the public exchange. Maria saves 1 dollar compared to buying at 42.02. The market maker still earns 3 cents of the 4 cent spread on her 100 shares, which is 3 dollars. Out of that, the market maker pays the broker perhaps half a cent per share, so 50 cents, as the PFOF. Everyone made something. Whether Maria got the absolute best possible price she could have gotten is a separate and genuinely hard question to answer.

Where it goes wrong

I once trusted a handshake deal simply because it had always worked before, and I did not ask who else was at the table. That is the quiet risk inside PFOF. The broker has a financial interest in sending orders to the market maker that pays the most. The question is whether that payment comes at the expense of your execution quality. Critics argue that a broker without PFOF might route to a public exchange where your order competes openly and could fill at an even better price. The SEC has debated restricting or banning PFOF for years. The European Union has moved to phase out the practice. In the United States it remains legal as of the time this page was last verified. A second risk is opacity. Most investors never read a 606 report. They do not know how their orders travel. Complexity protects the practice. A third concern applies specifically to options, where spreads are wider and PFOF payments are larger, meaning the tension between broker incentives and your best price is sharper. None of this means your broker is acting dishonestly. It means the system has a built in pull that deserves your attention.

Questions to answer before you leave this page

You deserve to leave here with real questions in hand, so consider sitting with these for a moment: Does your broker accept payment for order flow, and have you ever looked at their Rule 606 report to see how much they received and from whom? When you placed your last market order, do you know whether it was filled on a public exchange or by a market maker off the exchange, and do you know whether you could find out? If your broker advertises zero commissions, have you thought about what service or data they might be exchanging for that, and whether the trade sits well with you? Have you considered using limit orders instead of market orders, since a limit order tells the market maker the exact price you will accept, giving you more control over the spread you pay? If you trade options with any frequency, have you looked at the spreads on those contracts and thought about how much wider they are than stock spreads, and what that means for how much PFOF your orders might be generating? And finally, if you found out your broker received a larger payment for routing your order to one firm over another, would that change where you keep your account, and if not, why not?