Payment for Order Flow: What It Is and Why It Matters

User-friendly technology and the resulting lower transaction costs have helped fuel the recent increase in direct participation by retail investors in the stock market. But not all the cost benefits investors are experiencing may be the result of improved operating efficiency. Concurrent with the technological gains and shorter settlement process has been a rise in the use of payment for order flow at a number of brokerage firms.

For a clearer understanding of how payment for order flow impacts a broker-dealer’s cost structure, and prompt more frequent trading, we recently spoke with Mitchell B. Thornton, CPWA® Senior Vice President and National Director of Brokerage at Northern Trust Securities, Inc.

Q1: With some brokers now offering $0 commission trading fees, is there no longer a cost to trading?

A: Despite the well-advertised fall in brokerage commission rates, the cost of executing online trades has not fallen to zero for the broker-dealers who execute these trades, nor in our opinion for the clients who pay $0 on their trades. While most industry participants have passed their cost savings from higher operating efficiencies along in the form of reduced commissions, some have gone farther. They have stopped charging for online trades in favor of covering their execution costs with other forms of revenue, such as payment for order flow. This can lead to indirect costs.

Q2: Can you explain what payment for order flow is and its relationship to the zero-dollar transaction costs online traders enjoy?

A: Brokerage firms involved in payment for order flow receive money from third-party institutions in exchange for directing clients’ orders to the paying firm’s trading desk. This bypasses other market makers or exchanges irrespective of pricing. The revenue generated from the payments received for this guaranteed order flow has enabled participating brokerage firms to eliminate the commissions they charge for online retail trades. It should be noted that this type of arrangement has been around for years, and the Securities and Exchange Commission requires disclosure of these arrangements to customers under SEC Rule 606.

Q3: Firms taking part in the payment for order flow – both those paying for it and those receiving the payments – assert that it benefits all parties, including retail investors who now pay minimal if any commission. Why then are regulators and Congress concerned?

A: The assertion of it being a “win-win-win” for all parties, has not been proven yet. At a minimum, payment for order flow creates the appearance of a conflict of interest by giving firms an incentive to encourage frequent trading by their clients. The more clients trade, the larger the order flow a broker-dealer has available to sell.

Also, with so many trades now executed outside of the traditional exchange environment, there is concern that payment for order flow might impede market makers’ ability to provide investors with price discovery. That could diminish the ability to deliver the best execution price to clients as required by current regulations.

Q4: Why has Northern Trust Securities Inc., among other brokerage firms, made the decision to forgo the practice of selling its order flow?

A: Like other firms, we share our cost savings from using increasingly efficient electronic trading systems by discounting our commission schedules for all trades, online and those placed through our brokers. However, conceptually, we believe receiving payment for order flow would not keep us aligned with our clients’ best interests and could affect our own ability to provide best execution to our clients. We just do not want to be in that position.

Our Take: Accepting payment for order flow can present the potential for negative impacts or intrinsic “costs” to clients including:

• Lack of transparency
• Conflicts of interest
• Failure to deliver best execution

Q5: Given the concern for delivering “best execution” on each trade, how does Northern Trust Securities, Inc. approach the responsibility now?

A: We use a sophisticated proprietary trading infrastructure, which enables us to route orders to the best venue based on a multi-factor approach. This approach incorporates quote size, quote price, speed of execution, liquidity enhancement and the availability of price improvement. Then we leverage 80+ trading algorithms to execute trades across a variety of platforms, including domestic and international exchanges and private liquidity pools.

Q6: While the cost of transacting and being confident that “best execution” will be delivered with each trade are important, what else should investors consider when choosing a wealth management broker?

A: Many of our wealth management clients engage in stock transactions that benefit from a more customized and strategic approach. This is especially true for those who need to trade illiquid stocks or who require discretion for large block-sized transactions.

To learn more about how Northern Trust Securities supports your investing needs, contact a Northern Trust Securities, Inc. advisor.

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

Securities products and services are sold by registered representatives of Northern Trust Securities, Inc., (member FINRA, SIPC), a registered investment adviser and wholly owned subsidiary of Northern Trust Corporation. Investments, securities products and brokerage services are:
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