Key takeaways
- Payment for order flow (PFOF) is a system where exchanges or brokers route trades to specific market makers in exchange for a fee.
- PFOF can negatively affect high-frequency, arbitrage and day trading strategies by introducing slight delays and price markups, eroding profits.
- Critics argue that PFOF lacks transparency, as retail traders often don’t realize their trades are being routed through third parties, leading to hidden costs.
- Both the US and European regulators are considering reforms to PFOF practices, with the EU planning to phase it out by 2026, while the US debates stricter rules.
Ever wonder how trading platforms make money on 0% trades?
Well, this is where payment for order flow (PFOF) comes in — a system where crypto exchanges or brokers get paid for routing trades to specific market makers or liquidity providers. In simple terms, instead of executing your trade directly on the open market, brokers send it to a third party that pays them a small fee for the order.
What is payment for order flow (PFOF) in crypto?
Originally from traditional finance, where stock brokers would route trades to market makers for a kickback, PFOF has found its way into the crypto world. The brokers benefit from these payments because it’s an extra revenue stream for them, but traders often don’t see the immediate cost. That’s because while you’re not paying a direct fee, the market maker might not give you the best price, which subtly affects your overall trade cost.
Let’s say you’re trading on a platform like Robinhood, which is known to use PFOF. You want to buy 1 Bitcoin (BTC) for a market price of $60,000.
Instead of your order going directly to the market to match with the best available price, Robinhood might route your trade to a specific market maker like Citadel Securities. Citadel pays Robinhood a small fee — let’s say $0.01 per trade — for sending the order their way.
However, instead of getting Bitcoin at $60,000, Citadel might fill your order at $60,040, pocketing the difference. You, as the trader, might not notice the extra $40 added to your trade, but over time, these small markups can add up.
This is how PFOF works behind the scenes: The broker (Robinhood) gets paid by the market maker (Citadel), while you might end up paying a little more for your trade than expected, even though there’s no visible commission fee.
On a more transparent exchange like Binance, your order might have been executed directly at the current market price, meaning you would get your Bitcoin for exactly $60,000 without any hidden costs.
Did you know? Robinhood, launched in 2018, was the first platform to offer 0% commission crypto trading, disrupting traditional brokerage models by eliminating fees for small retail investors. However, it still earned fees by routing trades to specific market makers, which may not have always aligned with the trader’s best interest.
How does PFOF impact cryptocurrency traders?
PFOF tends to have the biggest impact on certain cryptocurrency trading strategies, especially those that rely on precise execution and minimal price differences. Here are a few key strategies affected:
- High-frequency trading (HFT): In high-frequency trading (HFT), milliseconds matter. Traders rely on fast execution to take advantage of tiny price movements. With PFOF, orders are routed through a market maker, which can introduce slight delays or less-than-optimal prices. Even a small discrepancy between the intended price and the executed price can eat into profits, especially since HFT strategies depend on volume and quick reactions.
- Arbitrage trading: Arbitrage traders make money by exploiting price differences between different markets or exchanges. If a trader is expecting to buy Bitcoin at $60,000 on one exchange and sell it for $60,100 on another, PFOF can interfere. Instead of getting the expected price, the trader might get a slightly worse price due to the order being routed, reducing the arbitrage opportunity or making it unprofitable altogether.
- Day trading and scalping: Day traders, who rely on frequent trades and small price movements, are also sensitive to PFOF. If you’re making a large number of trades throughout the day, paying even a slightly higher price on each trade — due to orders being sent through a market maker — can significantly affect your daily returns. Day traders aim to capture small price changes, so PFOF can erode those small gains over time.
In short, any strategy that relies on quick, frequent trades or small margins can be disproportionately affected by PFOF. The small price differences caused by PFOF might seem insignificant in one trade, but they can add up and harm profitability, especially for traders focused on precision and speed.
Why is PFOF controversial in crypto markets?
One of the primary controversies surrounding PFOF is the potential conflict of interest. After all, by receiving payments from market makers for routing trades, brokers may prioritize profit over getting the best price for their users.
This concern was front and center during the Robinhood and Citadel controversy following the GameStop trading frenzy in early 2021. Robinhood was accused of prioritizing its relationship with Citadel, a major market maker, which allegedly led to halting trades to prevent losses for large hedge funds.
Critics like United States Securities and Exchange Commission Chair Gary Gensler have raised concerns that this concentration of order flow to a few dominant market makers, such as Citadel, gives institutional firms an unfair competitive advantage.
Critics also point to the lack of transparency in the PFOF model. Traders often aren’t aware that their orders are being routed to third parties who may not offer the best possible price. Market makers profit from slight discrepancies in the bid-ask spread, and retail traders end up paying more without realizing it. Some industry experts argue that this undermines the very concept of a “fair” market.
On the regulatory front, the SEC has been actively discussing reforms to limit or even ban PFOF in US markets. In 2023, the SEC proposed rules that would increase competition for order flow, with a focus on improving transparency and ensuring that brokers act in the best interest of their clients.
While the European Union has announced plans to phase out PFOF by 2026, the US is still debating its future. Gensler has emphasized that the current system benefits market makers far more than retail investors.
Despite this, not everyone agrees that banning PFOF would solve these issues. Some experts argue that PFOF has democratized trading by allowing platforms like Robinhood to offer commission-free trades, making investing more accessible to everyday people. They contend that banning PFOF could lead to higher costs for retail investors, particularly if brokers lose this source of revenue and have to reintroduce trading fees.
In essence, the debate hinges on whether the cost of hidden fees and potential conflicts of interest outweigh the benefits of zero-commission trading. While regulation seems likely, it’s unclear whether banning PFOF outright would lead to better outcomes for traders.
Did you know? One of the lesser-known concerns about PFOF is its potential to increase market fragmentation. As trades are routed through specific market makers rather than executed on a central exchange, liquidity can become scattered across various venues. This fragmentation can lead to less efficient price discovery, meaning the true market value of an asset might not be reflected as quickly or accurately, which further disadvantages retail traders compared to institutional players.
How to minimize PFOF fees in crypto trading
While PFOF can lead to hidden costs in crypto trading, there are ways to reduce or avoid these fees altogether. Here are some practical tips for traders who want more control over their trading costs:
1. Use transparent exchanges
One of the easiest ways to avoid PFOF is by trading on platforms that are upfront about their fee structures. Exchanges like Binance or Kraken tend to be more transparent, charging direct fees instead of relying on PFOF. These platforms generally execute trades without routing them through third-party market makers, which means you’re more likely to get the best possible price.
For example, Binance uses a maker-taker fee structure that is fully disclosed before you trade. You can calculate your costs ahead of time, ensuring no hidden markups that could increase your overall trading expenses.
2. Switch to decentralized exchanges (DEXs)
Decentralized exchanges (DEXs) like Uniswap and SushiSwap are a great alternative for avoiding PFOF entirely. DEXs are built on smart contracts, meaning trades are peer-to-peer and don’t rely on centralized intermediaries like market makers. This cuts out the intermediary and reduces the likelihood of paying inflated prices.
On a DEX, the transaction occurs directly on the blockchain, and fees are usually transparent and based on the network’s gas fees rather than hidden costs from order flow routing. However, DEXs do come with their own set of risks, like higher fees during periods of network congestion, so it’s important to factor that into your decision-making.
3. Opt for brokers with lower PFOF dependency
If you prefer to stick with centralized exchanges or brokers, look for ones that don’t rely heavily on PFOF as their primary revenue stream. Some platforms, like Fidelity or Interactive Brokers, have minimized their dependence on PFOF and offer alternative ways of executing trades that could result in better pricing for traders.
These platforms often offer direct market access, which means your trades are executed on a public exchange rather than routed to a market maker. While you might still pay a small commission, it could be worth it to avoid the hidden costs associated with PFOF.
4. Consider OTC trading for larger orders
For traders dealing with larger amounts, over-the-counter (OTC) trading desks can be a better option. OTC trades are typically negotiated directly between buyers and sellers, and the focus is on finding the best price for large orders. Unlike PFOF, which tends to favor small, frequent trades, OTC desks provide custom pricing for significant orders and often don’t involve market makers.
5. Stay informed about fee disclosures
Finally, it’s crucial to stay informed about how your broker or exchange earns money. Under regulations like SEC Rule 606, brokers are required to disclose their order routing practices and how much they earn from PFOF. Checking these reports can give you insight into whether your broker is prioritizing the best execution or simply maximizing their PFOF revenues.
Did you know? As of 2024, DEXs like Uniswap and Raydium are handling over $139 billion in monthly trading volume, offering traders a way to avoid hidden fees typically associated with centralized platforms that rely on PFOF.
What the future holds for PFOF in crypto trading
As the debate around PFOF heats up, it’s clear that regulatory changes are on the horizon, especially in markets like the US and Europe.
With this in mind, one potential trend you could see is a shift toward more transparent trading platforms. As scrutiny over PFOF increases, exchanges that offer clear fee structures and direct market access may attract more traders looking to avoid hidden costs. DEXs like Uniswap and SushiSwap may also gain popularity since they bypass the need for centralized intermediaries and market makers, eliminating PFOF entirely from the equation.
However, as explored, it’s not all certain that PFOF will disappear. Some industry experts argue that as long as it remains a cost-effective way for platforms to offer zero-commission trading, brokers and exchanges may continue to push back against a full ban. This could lead to a compromise regarding regulations where more transparency is required but PFOF isn’t outlawed.
In the coming years, expect to see more innovation in trading models as platforms seek ways to balance profitability and fairness. Whether newer, more equitable systems emerge or existing models adapt, one thing is clear: Traders should stay informed about how these changes could impact their costs and strategies.
Written by Bradley Peak