Directed order flow occurs when a customer’s order to buy or sell securities is given specific instructions for the order to be routed to a particular exchange or venue for execution.
The choice of exchange or venue for order execution may be left up to the end customer, or else left up to the broker or dealer.
Payment for order flow is a way of bidding for directed order flow, which typically benefits brokers.
A directed order is so named because the client directs the order routing for execution. The client preference for a particular exchange for execution may be based on the view that incrementally better execution prices are available there for trading a particular stock or security. This is a factor that is of significantly greater importance to the active trader than it is to the average retail investor.
In ordinary trading, non-directed orders are those where the client does not specify a particular venue for order execution. The choice of exchange or venue for order execution, in this case, is left up to the broker or dealer. In an effort to facilitate transparency and prevent wrongdoing with regard to routing of non-directed orders, the SEC adopted Rule 11Ac1-6 in November 2000, requiring all broker-dealers to furnish quarterly reports that disclose their order routing practices. Rule 11Ac1-6 was subsequently replaced by Rule 606.
As trading venues have increasingly consolidated while offering similar service levels, the advantages of directed order flows have dissipated. The proliferation of electronic communication networks (ECN) has been instrumental in eroding arbitrage opportunities available from directed orders. However, with greater use of algorithms, machine learning, and similar quantitative-driven investment strategies, robotic selection of preferred trading venues looks to be setting up something of a renaissance in directed order selection.
In reality, today’s techniques to achieve best-execution for trade orders has become less about directed, and non-directed order flows, and more about whether an order is deemed aggressive or passive. Aggressive orders are entered into the order book of a trading venue and extract market liquidity; while passive orders add to market liquidity.
Payment for directed order flow is legal, but remains a controversial practice.
Payment for order flow is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. The brokerage firm receives a small payment, usually a penny per share, as compensation for directing the order to different third parties.
The nature of compensation for order flow is what is essential. In a payment for order flow scenario, a broker is receiving fees from a third party, at times without a client’s knowledge. This naturally invites conflicts of interest and subsequent criticism of this practice. Today, most brokers offer clear policies surrounding this practice.
Your brokerage firm is required by the SEC to inform you if it receives payment for sending your orders to specific parties. It must do this when you first open your account as well as on an annual basis. The firm must also disclose every order in which it receives payment.