Understanding the behind-the-scenes mechanics of investing can be as crucial as picking the right stocks. One such mechanism is payment for order flow (PFOF). This concept plays a pivotal role in how your stock trades are executed and how your broker makes money. But what exactly is it, and why is it a topic of heated debate among investors, brokers, and regulators alike?
What is payment for order flow?
PFOF is a revenue model for brokers. When you invest on the stock market, there are two key players: brokers (like Trade Republic or DEGIRO) and market makers (like Tradegate). Brokers execute trades for individual investors, while market makers are firms that actively buy and sell stocks, providing liquidity to the market. When you, as an investor, place a stock trade through a broker, instead of sending your order directly to a stock exchange, the broker might send your order to a market maker. The market maker executes the trade on your behalf.
Most brokers will pick the market maker that offers you the best price. But in the PFOF model, the market maker will pay the broker to handle these trades. This fee is the "payment for order flow".
How it benefits investors
This practice can lead to lower commission fees for investors. Since brokers receive payments from market makers, they might not charge you a commission for trades. This is visible in the table below, which shows the transaction fee for buying €1,000 of the IWDA ETF. Trade Republic and DEGIRO, two brokers that adopted the PFOF model, are among the cheapest.
Why it can also harm investors
While it can lead to lower costs, PFOF is controversial. It creates a conflict of interest for brokers and might result in worse execution prices for investors. After all, the broker will route the trades to the market maker that pays them the highest fee, rather than the one that will offer you the best price (which the lowest price when buying a stock and the highest when selling).
The Dutch regulator AFM researched the price of Dutch stocks for PFOF and non-PFOF brokers and found that PFOF leads to worse prices in most cases:
The analyses found that the majority of retail client transactions on the two PFOF trading venues were executed at prices worse than transactions on the reference trading venues. On the non-PFOF trading venue, most of the retail client transactions have similar execution prices when compared to the reference trading venues.
The CNMV, the Spanish regulator, came to a similar conclusion for Spanish stocks:
It shows that for the trades executed on behalf of the PFOF broker’s clients through the PFOF TV on Spanish stocks during the first half of 2021, best execution was seldom achieved (only a 3.3% of the trades) and in most cases (86%) the prices obtained by clients were worse than the worse alternative in the group of comparable trading venues. The average price deterioration is estimated at €1.09 per €1,000 traded.
There's also a concern about transparency and whether investors fully understand how their trades are being handled.
It's banned in the EU from 2026
Because of the controversy, the European Union has decided to ban payment for order flow from 2026 onwards. Until then, member states can allow PFOF but only for clients in that member state. So Trade Republic can earn money through PFOF for its German clients until 2026, but not for its Belgian clients for instance.
Which brokers earn revenue through payment for order flow?
The following brokers are known to have adopted the PFOF model:
- DEGIRO through the Tradegate exchange
- Trade Republic through the Lang und Schwarz exchange
- Scalable Capital through the gettex exchange
eToro applies PFOF for its American clients, where it's legal. But it's unclear if they also do it for their European clients.
Summary
Payment for order flow is a revenue model for brokers that allowed them to lower their commissions. However, it's not without controversy. Because of this, the EU decided to ban it from 2026, which will impact brokers like DEGIRO and Trade Republic.
Questions you may have
Why is payment for order flow bad?
Perhaps the most significant concern with PFOF is the potential conflict of interest. Brokers are incentivized to route orders to the market maker that pays them the most, rather than the one that might provide the best execution for your trade. This can potentially lead to worse execution prices. On top, PFOF can obscure the true cost of trading.
Where is payment for order flow banned?
PFOF has been banned in the UK since 2012. And it will be banned across the European Union from 2026 onwards.