“Payment for order flow,” or PFOF, refers to 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 trade profitably against client orders, 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.”
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 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 such compliance factors as price, volatility, relative liquidity, size and type of transaction, the number of markets checked, and accessibility of the quotation. It expects firms to use “reasonable diligence” in caring for best execution. 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 (FINRA’s “Best Execution Outside-of-the-Inside Report Card” is an excellent source for potential metrics)
- 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 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.’”
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:
- Number of shares executed
- Information on order routing
- Information on order execution
- Information on orders that provided or removed liquidity
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.
Conclusion: Proceed with Caution on Payment Order Flow (PfOF)
Payment for order flow 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.