Broker-Dealers
Payment for Order Flow (PFOF) and FINRA Rule 5310: A Guide for Online Broker-Dealers
Nov 28, 2023
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InnReg
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5 min read
Contents
“Payment for order flow,” or PFOF, refers to the compensation a broker receives from a wholesale market maker in return for routing trades to that market maker. This approach to compensation is at the heart of many digital broker-dealers’ business models. It allows them to earn additional revenue, while their retail clients theoretically benefit from lower or no commissions.
When it comes to PFOF, however, digital broker-dealers may be tempted to route trades to the highest bidder rather than to market makers who offer the best price and fastest execution. Such an arrangement could be more profitable for the broker while being detrimental to the end investor.
FINRA Rule 5310, also known as the “Best Execution” rule, comes into play to address this potential conflict of interest. Per FINRA, Rule 5310 requires that “in any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”
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Increased Scrutiny: Reasons and Consequences
Best Execution has come into prominence as some of the largest retail investment apps go public and become mainstream. At the start of 2019, FINRA listed best execution among its examination priorities. Most notably, in December 2020, the SEC charged investment app Robinhood “for repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders.”
The issue proved costly to Robinhood, resulting in an agreed settlement of $65 million. It was only one of many issues the company faced from both federal and state regulators. It was not the first time. In December 2019, FINRA fined Robinhood $1.25 million for earlier best execution violations.
More broadly, we are seeing talk in regulatory and policy circles about banning PFOF entirely. At the end of August 2021, SEC Chair Gary Gensler openly admitted that a total ban of payment for order flow (PFOF) is “on the table.” Market opinion-makers have rightly signaled this as a significant concern for online broker-dealers.
FINRA Rule 5310: Compliance Factors
Regardless of the future of PFOF, online broker-dealers need to comply with the current Rule 5310 provisions. This need has only become more acute as a result of high-profile cases such as Robinhood.
FINRA Rule 5310 cites required compliance factors to be considered in determining the market, such as the price, volatility, relative liquidity, pressure on available communications, size and type of transaction, the number of markets checked, the accessibility of the quotation, and the terms and conditions of the order. It expects firms to use “reasonable diligence” in reviewing the factors noted above. In addition, broker-dealers must conduct “regular and rigorous” reviews of the execution quality of customer trades if they do not conduct individual compliance reviews of every transaction instead.
These FINRA expectations, unfortunately, have a significant subjective dimension to them. In the work InnReg does to develop end-to-end compliance programs for broker-dealers, we focus on factors that we call the “Three Cs”:
coherent approach to best execution,
consistent consideration of trades, and
continuous improvement of the monitoring and remediation process.
A Payment for Order Flow Checklist
While some aspects of best execution depend on a broker-dealer's specific business model, InnReg has identified some general principles applicable to most scenarios. Following these principles may not guarantee best execution for each individual trade, but they are essential to demonstrating reasonable diligence.
Create a written Best Execution policy and train all relevant staff
Define clear and consistent metrics that can capture the performance of any trade
Document steps you have taken to determine and monitor best execution
Conduct periodic reviews and audits of trade performance (quarterly, at minimum)
Report on all exceptions when best execution obligations are not met
Identify and remediate any systemic issues (i.e., specific situations where trades fail performance tests upon review)
Review and update all policies and procedures regularly, especially in response to changes in routing arrangements and order routing technology
Disclose order routing information as required by SEC Rule 606
Payment for Order Flow (PFOF) Disclosure Requirements
Customer disclosure was a core element in the SEC’s charges against Robinhood. In its release, the SEC stated that “Robinhood made misleading statements and omissions in customer communications, including in FAQ pages on its website, about its largest revenue source when describing how it made money – namely, payments from trading firms in exchange for Robinhood sending trades to those firms for execution, also known as ‘payment for order flow.’”
Regulatory Framework for Disclosure
SEC Rule 606 establishes what broker-dealers must disclose. In the past, such disclosure requirements included only minimal information. New and expanded disclosure requirements that came into effect on June 1, 2020 include:
Enhanced disclosure on order handling
Upon request, provide information on not held orders for the previous six months
Enhanced the aggregated order routing disclosures on a quarterly basis
More detailed disclosures of payments received
Information on terms of payment for order flow arrangements
Initial and Ongoing Disclosure Obligations
Brokerage firms are required to inform clients about their PFOF arrangements when opening an account and to update them annually. This helps keep investors continually informed about how their trades are being managed.
Report Availability and Client Access
Regulation NMS mandates that broker-dealers provide two critical reports: one to disclose execution quality and another to outline PFOF statistics. The update to Rule 606 in 2020 also requires brokers to disclose net payments received each month and the PFOF per 100 shares by order type, such as market, marketable-limit, and nonmarketable-limit orders.
Moreover, brokerage customers can request specific payment data for individual transactions, although this process may take weeks. This access empowers clients with a deeper understanding of their transactions.
Transparency in Marketing
In addition, as the charges against Robinhood illustrate, firms are also under an implied obligation to demonstrate transparency in their marketing and customer-facing materials. Thus, best execution should be among the factors included in all compliance reviews of marketing and advertising as well.
What Are the Potential Benefits of PFOF?
While PFOF may facilitate better execution prices and greater market liquidity, it has been criticized for creating unfair conditions at the expense of retail traders and investors. However, the SEC permitted PFOF with the belief that its advantages could outweigh the drawbacks.
Here are some key benefits of PFOF:
Support for Smaller Brokerages: Smaller brokerage firms often struggle with large order volumes. PFOF allows these firms to route some orders to market makers, which can enhance their operational efficiency.
Cost Savings for Customers: Brokers receiving PFOF compensation may end up passing some of these financial benefits to customers. This is often seen in the form of lower trading costs, such as reduced or zero commissions.
Expanded Access for Retail Traders: The reduction in fees has significantly broadened access for retail traders, enabling them to engage in the market at a fraction of the previous costs.
These benefits, however, are contingent upon PFOF delivering better overall value through execution quality rather than merely reducing commission costs. If PFOF results in inferior execution, the advantages could be nullified, costing customers more than they save.
What Are the SEC Requirements and Regulations Regarding PFOF?
To understand the regulatory landscape of PFOF, it’s important to consider both historical context and evolving oversight by the SEC. Several key regulations shape how broker-dealers handle order flow today.
Regulation NMS and the National Best Bid and Offer (NBBO)
In 2005, the Regulation National Market System (NMS) was set out to modernize US equity markets by promoting fairness, competition, and investor protection. A central component of this regulation is the National Best Bid and Offer (NBBO) requirement, which mandates that trading venues execute orders at the best available bid or offer across all exchanges. This rule promotes competitive pricing for investors, especially retail clients, across all routing venues.
See also:
Rule 606: Enhanced Order Routing Disclosures
Rule 606 governs how broker-dealers disclose information about their order routing practices. Initially focused on general disclosure, the rule was significantly revised effective June 1, 2020, to require much more granular reporting.
Under the updated rule, brokers must provide detailed quarterly reports that include data such as how and where those orders were routed.
In addition, firms must disclose net payments received from market makers for both equity and options trades, broken down by order type. These enhanced requirements are designed to give regulators and investors better insight into how brokers manage order flow and whether their practices align with best execution standards.
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Proposed Updates to Rule 605: Execution Quality Reporting
In December 2022, the SEC proposed changes to Rule 605 to enhance the disclosure of order execution information for investors. The proposed updates apply to broker-dealers handling more than 100,000 customer accounts, extending the rule’s reach beyond market centers to include a larger portion of retail-facing firms.
This expansion aims to give investors and regulators more comprehensive tools to evaluate how firms handle customer orders and whether those orders are being executed under the most favorable terms.
Rule 615: Proposed Order Competition Rule
One of the most consequential recent developments in the SEC’s oversight of PFOF is the proposed Rule 615, also known as the Order Competition Rule. If adopted, this rule would require most retail orders to be exposed to a short auction before execution, allowing multiple trading venues to compete for the order.
The objective is to reduce firms’ reliance on internalized order flow and PFOF arrangements, which often lack transparency and may create conflicts of interest. By introducing competitive auctions into the execution process, the SEC hopes to improve pricing for retail investors and create a more level playing field across the market.
Why This Matters for Online Broker-Dealers:
If implemented, Rule 615 would significantly reshape how online broker-dealers manage order routing. The proposed requirement for order-by-order auctions could necessitate substantial changes to internal systems, demanding both technical upgrades and revised workflows.
These reforms would also raise the bar for regulatory compliance, particularly around best execution standards, and challenge the foundational economics of the PFOF model many firms currently rely on.
To prepare, broker-dealers should begin by evaluating whether their existing technology infrastructure can support real-time auction functionality. It's equally important to revisit best execution policies to confirm that documentation, metrics, and analysis processes are robust enough to meet expanded regulatory expectations.
Finally, firms should bring legal and compliance teams into the conversation early to map out potential operational adjustments and preemptively address disclosure and governance gaps.
Conclusion: Proceed with Caution on Payment Order Flow (PFOF)
PFOF has become a controversial topic, and recent SEC comments suggest that the topic may remain contentious. For now, however, FINRA Rule 5310 establishes the parameters that regulators expect firms to put in place.
FINRA members that generate revenue via PFOF should pay close attention to regulatory developments and enforcement actions related to this topic. In addition to regulatory and enforcement updates, please contact us if you have any questions about your current risk exposures, controls, and compliance improvement opportunities.
How Can InnReg Help?
InnReg is a global regulatory compliance and operations consulting team serving financial services companies since 2013.
We are especially effective at launching and scaling fintechs with innovative compliance strategies and delivering cost-effective managed services, assisted by proprietary regtech solutions.
If you need help with broker-dealer compliance, reach out to our regulatory experts today:
Published on Sep 26, 2021
Last updated on Nov 28, 2023
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