What Everybody Ought to Know about Payment For Order Flow

When I first began trading in 2001, a market making firm named Susquehanna Investment Group came up with a new and innovative idea to bring volume to the Pit’s where they controlled the most volume. Pits where they were the Specialist, or the Designated Primary Market-Maker or DPM. 
This was called payment for order flow.  The exchanges call them ‘marketing fees’ and your broker may call it one of many names. 
What seemed like a bright idea at the time has blossomed into a situation that is:

• Bad for the customer
• Bad for the liquidity provider
• GREAT for your online broker

 In the following years, the system would slowly become integrated by the exchanges and taken out of the individual firm’s hands.  The system has essentially morphed into a hierarchy that puts trading firms who are willing to pay to see larger orders in the driver’s seat, and the public, in the trunk.  I will not broach the hierarchy subject for large orders but I will explain why it is important that one takes the time to review the status of their order.

GETTING THE FIRST LOOK
Back to Susquehanna, the well meaning market making firm that opened Pandora’s Box.  (I will be picking on Susquehanna during this article, but this is industry practice. I do not want the reader to think they are the only firm that does this. As stated above, most EXCHANGES now engage in this practice).  They made agreements with many trading firms to get a ‘first look’ at all of the paper that a certain firm has.  But what does that ‘first look’ really mean?

• If Susquehanna is matching the NBBO, and the order is hitting the NBBO, the order will route to Susquehanna’s pit. 
• If Susquehanna wasn’t best bid or offer, depending on the order, Susquehanna might still get first look at the order.  By routing through linkage, the order would get sent to the exchange with the best bid or offer. 
• If Susquehanna was matching the NBBO, and an order did not hit the NBBO, the order would still route to Susquehanna.  As a retail trader one might look at that deal and think that it isn’t so bad.  That trader would be sorely mistaken.

The first part of the deal likely has little affect on retail traders as they are hitting the NBBO.  Likely their order will get filled.  The only time this would be a problem is if the trader is sending a large trade and the order is being sent to the exchange with the smallest bid or offer.  It is possible that a small portion of the traders order could get filled, and while being linked to another exchange the market changes on the trader.  This would leave the trader open on a portion of his or her trade.  

The second situation where Susquehanna isn’t on matching the NBBO, yet sees the order first, then routes the order through linkage, is slightly more problematic.  If there is only one exchange bid at a certain level.  The seconds it takes the order to move from the Susquehanna through linkage to the exchange a market can certainly move (actually I believe many firms that accept payment for order flow have some sort of matching guarantee to protect their customers from this occurrence).

Finally, the real culprit, a non-marketable order gets sent to the Susquehanna pit.  The example I am about to run through actually happened to me in IBM. 

This is an oversimplified description of payment for order flow, but hopefully it opens the trader’s eyes.  Keep a watchful eye for orders that may be misrouted, smart-routed orders. 

WHAT CAN YOU LEARN FROM THIS?

• It is important for traders to monitor the order! 
• If you send an order that isn’t being filled, re-route it.  Send it to an exchange that has more volume, a bigger bid, or a bigger offer. 

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