Subject: Trading - Order Routing and Payment for Order Flow

Last-Revised: 25 Nov 1999
Contributed-By: Bill Rini (bill at, Terence Bergh, Chris Lott (contact me), W. Felder

A common practice among brokerage firms is to route orders to certain market makers. These market makers then "rebate" 1 to 4 cents per share back to the brokerage firm in exchange for the flow of orders. These payments are known as "payment for order flow" (PFOF). (The account executive does not receive this compensation.) Order routing and PFOF occurs in stocks traded on the NYSE, AMEX and NASDAQ. NYSE and AMEX stocks traded away from the exchange are said to be traded "Third Market."

Payment for order flow has been a mechanism that for many years has allowed firms to centralize their customers' orders and have another firm execute them. This allowed for smaller firms to use the economies of scale of larger firms. Rather than staffing up to handle 1,000, 5,000 or so orders a day, a firm can send it's 1,000 or 5,000 orders to another firm that will combine this with other firm's orders and in turn provide a quality execution which most of the time is automated and is very broad in nature. Orders are generally routed by computer to the receiving firm by the sending firm so there is little manual intervention with orders. This automation is an important part of this issue. Most small firms cannot handle the execution of 3,000 or more different issues with automation, so they send their orders to

those firms that can.

For example, Firm A can send it's retail agency orders to a NASDAQ market maker or Third Market dealer (in the case of listed securities) and not have to have maintain day-in and day-out the infrastructure to "handle" their orders. In return for this steady stream of retail order the receiving firm will compensate Firm A for it's relationship. This compensation will generally come in the form of payment per share. In the NASDAQ issues this is generally 2 cents, while in NYSE issues its 1 cent per share. Different firms have different arrangements, so what I have offered is just a rule of thumb.

These "rebates" are the lifeblood of the deep discount brokerage business. Discount brokerage firms can afford to charge commissions that barely cover the fixed cost of the trade because of the payments they receive for routing orders. But understand that payment for order flow is not limited to discounters, many firms with all types of MO's use payment for order flow to enhance their revenues while keeping their costs under control. Also understand that if you require your discount broker to execute your orders on the NYSE (in the case of listed securities), you will find that the broker you are using will eventually ask you to pay more in commissions.

Firms that pay for order flow provide a very important function in our marketplace today. Without these firms, there would be less liquidity in lower tier issues and in the case of the Third Market Dealers, they provide an alternative to a very expensive primary market place i.e. NYSE and ASE. For example if you take a look at Benard Madoff (MADF) and learn what their execution criteria is for the 500 to 600 listed issue that they make a market in, you would be hard pressed to find ANY difference between a MADF execution and one executed on the NYSE. In some cases it will even be superior. There are many Third Market Firms that provide quality execution services to the brokerage community, DE Shaw, Trimark are two others that do a great job in this field. However, please realize that the third market community would have a hard time existing without the quote, size and prints displayed by the primary exchanges.

The firm that receives payment for its order flow must disclose this fact to you. It is generally disclosed on the back of your customer confirmation and regularly on the back of your monthly statement. This disclosure will not identify the exact amount (as it will vary depending on the order involved, affected by variables such as the market, limit, NMS, spread, etc.), but you can contact your broker and ask how much was received for your order if in fact payment was received for your order. You will probably get a very confused response from a retail broker because this matter (the exact amount i.e., 2 cents or 1.5 cents ) will generally not be disclosed to your individual broker by the firm he/she is employed by.

It is hard to "tell" if your order has been subject to payment. Look closely at your confirmation. For example if the indicated market is NYSE or ASE then you can be rest assured that no other payment was received by your firm. If the market is something like "other" coupled with a payment disclosure, your order may in fact be subject to payment.

There are two schools of thought about the quality of execution that the customer receives when his/her order is routed. The phrase "quality of execution" means how close was your fill price to the difference between the bid/ask on the open market. Those who feel that order routing is not detrimental argue that on the NASDAQ, the market maker is required to execute at the best posted bid/ask or better. Further, they argue, many market making firms such as Mayer Schweitzer (a division of Charles Schwab) execute a surprising number of trades at prices between the bid/ask. Others claim that rebates and conflict of interest sometimes have a markedly detrimental affect on the fill price. For a lengthy discussion of these hazards, read on.

To realize the lowest overall cost of trading at a brokerage firm, you must thoroughly research these three categories:

  1. The broker's schedule of fees.
  2. Where your orders are directed.
  3. If your NYSE orders are filled by a 19c-3 trading desk.

Category 1 includes "hidden" fees that are the easiest costs to discover. Say a discount broker advertises a flat rate of $29.00 to trade up to 5,000 shares of any OTC/NASDAQ stock. If the broker adds a postage and handling fee of $4.00 for each transaction it boosts the flat rate to $33.00 (14% higher). Uncovering other fees that could have an adverse impact on your ongoing trading expenses requires a little more digging. By comparing your broker's current fees (if any) for sending out certificates, accepting odd-lot orders or certain types of orders (such as stops, limits, good-until-canceled, fill-or-kill, all-or-none) to other brokers' schedules of fees, you'll learn if you're being charged for services you may not have to pay for elsewhere.

Category 2 is often overlooked. Many investors, especially those who are newer to the market, are not aware of the price disparities that sometimes exist between the prices of listed stocks traded on the primary exchanges (such as the NYSE or AMEX), and the so-called "third marketplace." The third marketplace is defined as listed stocks that are traded off the primary exchanges. More than six recent university studies have concluded that trades on the primary exchanges can sometimes be executed at a better price than comparable trades done on the third market.

Although there is nothing intrinsically wrong with the third market, it may not be in your best interest for a broker to route all listed orders to that marketplace. If you can make or save an extra eighth of a point on a trade by going to the primary exchange, that's where your order should be directed. After all, an eighth of a point is $125.00 for each 1,000 shares traded.

Here's how the third market can work against you: Say you decide to purchase 2,000 shares of a stock listed on the NYSE. The stock currently has a spread of 21 to 21 1/4. Your order, automatically routed away from the NYSE to the third market, is executed at 21 1/4. Yet at the NYSE you could have gone in-between the bid-ask and gotten filled at 21 1/8, a savings of $250.00.

Only a few of the existing deep discount brokers will route your listed stock orders to the primary exchanges. Most won't as a matter of business practice even if asked to do so. The only way to be sure that your listed stock orders are being filled on the primary exchanges is to carefully scrutinize your confirmations. If your confirmation does not state your listed order was filled on the NYSE or AMEX then it was executed on the third market.

You run the greatest risk of receiving a bad fill -- or sometimes missing an opportunity completely -- whenever you trade any of the stocks added to the NYSE since April 26, 1979, and your trade is routed away from the primary exchange onto the third market. Almost all AMEX stocks run this risk.

Category 3 was understood only by the most sophisticated of investors until recently. A 19c-3 trading desk is a (completely legal) method of filling NYSE orders in-house, without exposing the orders to the public marketplace at all. Yes, you'll get your orders filled, but not necessarily at the best prices. NYSE stocks listed after April 26, 1979, sector funds (primarily "country" funds such as the Germany Fund or Brazil Fund), and publicly-traded bond funds are the securities traded at these in-house desks. Recently, the NYSE approached the Securities Exchange Commission asking that Rule 19c-3, that allows this trading practice, be repealed. Edward Kwalwasser, the NYSE's regulatory group executive vice president stated flatly that, "The rule hasn't done what the Commission thought it would do. In fact, it has become a disadvantage for the customer."

Here's a scenario that helps explain the furor that has developed over the 19c-3 wrinkle. Let's say that XYZ stock is trading with a spread of 9 1/2 to 9 3/4 per share on the floor of the NYSE. An investor places an order to buy the stock and the broker routes that order away from the NYSE to the internal 19c-3 desk. The problem emerges when the order reaches this desk, namely that the order is not necessarily filled at the best price. The desk may immediately fill it from inventory at 9 3/4 without even attempting to buy it at 9 5/8 for the customer's benefit -- this is the spread's midpoint on the floor of the exchange. Then, after filling the customer's order internally, the firm's trader may then turn around and buy the stock on the exchange, pocketing the extra 12 1/2 cents per share for the firm. Project this over millions of shares per year and you can get an idea of the extra profits some brokers are squeezing out at the expense of their trusting, but ignorant, customers.

You can most likely resolve this dilemma between low commissions and quality of execution by examining the volume of trades you do. If you buy a few shares of AT&T once a year for your children, then the difference in fees between a trade done by a discount broker as compared to a full-service wire house will most likely dominate an 1/8 or even a 1/4 improvement in the fill price. However, if you work for Fidelity (why are you reading this?) and regularly trade large amounts, then you certainly have negotiated nicely reduced commissions for yourself and care deeply about getting a good fill price.

Finally, the whole issue may become much less important soon. Under the new rules for handling limit orders on the NASDAQ market, payment for order flow is becoming more and more burdensome on execution firms. With the advent of day trading, specialty firms that use the NASDAQ's SOES execution system, along with other systems to "game" the market makers, the ability of firms to pay others for their orders is becoming increasingly difficult. This "gaming" of the market place is due to different trading rules for different market participants (this issue by itself can take hours to explain and has many different viewpoints). Many firms have discontinued paying for limit orders as they have become increasingly less profitable than market orders.

As of November 1999, the Wall Street Journal that payment for order flow is a practice that is dying out fairly rapidly.

Note: portions of this article are copyright (c) 1996 by Terrence Bergh, and are taken from an article that originally appeared in Personal Investing News, March 1995.

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