A payment for order flow is a term used to describe the returns or compensation that a broker receives by forwarding orders received from clients for execution. While this type of payment is extremely small, forwarding a large number of orders to third parties for processing can be very lucrative. Typically, this approach is employed when the brokerage has received a large number of orders that need to be executed immediately, but the resources of the firm preclude the ability to process those orders in a timely manner.
Using a payment for order approach is not uncommon with smaller brokerage firms. Since firms of this type often rely on a smaller pool of brokers to keep up with client demands in terms of buy and sell orders, working with another brokerage as a partner is often a practical approach. In the event that the firm has more orders to process than can be managed with in-house resources, the overflow orders are routed to one or more partner firms who then manage the process. Instead of collecting the entire charge for processing the order, the small broker receives a much smaller fee for the transaction, with the firm handling the actual placement being the main recipient of the transaction fees.
The benefit to the small firm is that by having a payment for order flow process in place, it is possible to ensure client transactions are processed in a timely manner, even if the volume is more than the broker can handle with in-house resources. While the firm does not receive a full commission, the small fee that is provided by the partner firm is usually considered superior to losing the business altogether. In addition, the arrangement also makes it easier to hold onto current clients who otherwise might be tempted to find another brokerage.
The partner firms in a payment for order flow arrangement also benefit. The ability to receive and process the overflow orders means additional business that translates into more charges. By working with several small firms to handle volume orders, the brokerage effectively creates more revenue streams that help to augment the income that is generated by investors who are direct clients of the firm.
In most nations, brokers who arrange a payment for order flow strategy with other firms must disclose this fact to their clients. This allows those clients to determine if they are comfortable with this arrangement, or if they need to find a brokerage that will process transactions in-house. Failure to make this type of disclosure can lead to incurring fines and possibly rendering the brokerage from being able to conduct trades in some markets for a period of time, situations that can quickly offset any revenue gained from making use of the payment for order flow approach.
