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Key Takeaways
- PFOF is compensation a broker receives for routing customer orders.
- Commission, routing compensation and execution price are separate amounts.
- Best-execution duties apply to the broker’s routing decisions.
- The worked 200-share fill saves $3 against the offer and costs $1 above midpoint.
- Rule 606 reports identify covered routing destinations and payment relationships.
What is payment for order flow (PFOF)?
Payment for order flow, or PFOF, is compensation a broker receives for directing customer orders to a market maker, exchange or other execution destination. Arrangements can use per-share, per-contract or other economic terms. The payment goes to the broker, not the customer, and it is separate from the commission the customer pays and from the price the order receives.
The customer’s commission, the broker’s routing compensation and the order’s execution price are separate amounts. Reading each one makes the economics of the transaction clear.
Formula
Effective spread on a buy = 2 × (execution price − quote midpoint at order receipt); on a sell = 2 × (quote midpoint at order receipt − execution price)- SEC Rule 600(b) defines average effective spread this way for Rule 605 reports, so a published figure compares directly with the same calculation on your own fills.
- The quote midpoint is halfway between the national best bid and national best offer when the broker received the order.
- A lower effective spread indicates a better execution price relative to the midpoint, and the figure turns negative when a fill beats the midpoint.
PFOF example: price improvement and effective spread
When the broker receives a 200-share market buy for XYZ, the NBBO is $49.98 bid and $50.02 ask. The order fills at $50.005.
- Quote midpoint: ($49.98 + $50.02) / 2 = $50.00
- Fill cost: 200 × $50.005 = $10,001
- Improvement versus offer: ($50.02 − $50.005) × 200 = $3
- Cost versus midpoint: ($50.005 − $50.00) × 200 = $1
- Effective spread: 2 × ($50.005 − $50.00) = $0.01 per share
The $10,001 fill is $3 below the $50.02 offer benchmark and $1 above midpoint. Its effective spread is one cent per share. The broker’s routing payment is a separate transaction between the destination and broker.
The broker receives a 200-share buy when XYZ is quoted at $49.98/$50.02, with a $50 midpoint. The fill at $50.005 costs $10,001.
That price is $0.015 below the offer, producing $3 of quote improvement. It is $0.005 above midpoint, producing a $1 midpoint comparison.
The direction-adjusted effective spread doubles that midpoint difference: 2 × $0.005 = $0.01 per share. For a sell, subtract execution price from midpoint before doubling. A fill through midpoint in the customer’s favor produces a negative effective spread under this convention.
Why is payment for order flow controversial?
Routing payments can create a conflict because the destination that pays the broker most may not provide the best execution for the customer. Brokers must compare execution quality across competing markets, including price, speed, size and fill likelihood. Price improvement over the displayed offer is one input; the best destination comes from that full comparison.
How Rule 606 and best execution apply to PFOF
Rule 606 disclosures identify significant covered routing destinations and material economic relationships. Best-execution duties require the broker to evaluate execution under the applicable rule, including price, speed, likelihood and size.
Stock quantities count shares and listed option premiums use each contract’s multiplier, so price an option fill’s improvement per contract. Combine the actual fill price and quantity with the commissions and fees to reconcile the trade’s cash amount.
Limitations of PFOF disclosures
- Read the Rule 606 report for where a broker routes orders and what it is paid, and your own fills for the execution quality each order received.
- Measure improvement against the quote at order receipt. In a fast market the reference quote moves, and a small improvement can sit alongside a routing payment larger than the improvement.
- Compare brokers on their own figures: arrangements differ by broker, venue and product, and stock and option payments use different units.
- Judge execution on speed, fill likelihood and size as well as price, the factors best-execution rules weigh. Review them across many orders, where fill likelihood and speed show up in the pattern.
Bottom line
Payment for order flow is a routing payment to the broker, separate from your commission and your fill price. Judge it by the executions you actually receive: compare fills with the quote, read the broker’s Rule 606 report, and measure the effective spread on your own orders.
Clear answers
Frequently Asked Questions
Sources and Further Reading
- SEC: Payment for Order Flow and Market Structure
- SEC: Frequently Asked Questions About Rule 606
- FINRA: Rule 5310, Best Execution and Interpositioning
How entries are sourced, calculated and updated: editorial methodology.