Do Payments to Brokers for Order Flow Benefit Traders?

Do brokers who accept payments for order flow (PFOF) pass this income through to customers in the form of cheaper trade execution? In his June 2022 paper entitled “Price Improvement and Payment for Order Flow: Evidence from A Randomized Controlled Trial”, Bradford Lynch compares execution quality for trading randomly selected U.S. common stocks with at least $10 million daily average dollar volume and a minimum price of $5.00 at the market at random times during normal market hours with the following three brokers:

• A broker that utilizes direct access to exchanges (Interactive Brokers).
• A broker that utilizes wholesale brokers and extensive use of PFOF (Robinhood).
• A broker that utilizes wholesale brokers and modest use of PFOF (TD Ameritrade).

He opens and closes each position the same day with holding time at least five minutes. He uses randomized order sizes representative of retail trades ($1,000 or $4,000). He measures execution quality relative to the national best bid and offer (NBBO) at the time the order is placed, with price improvement based on buys (sells) executed below the ask (above the bid), as follows: (1) proportion of trades with price improvement; (2) price improvement per share as a percent of share price; (3) effective half-spread divided by quoted half-spread; and, (4) execution speed (time between order placement and first execution). Using the specified trade and quote date for about 250 trades per broker during the 20 trading days starting May 25, 2022, he finds that: (more…)