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Order flow is a practice in the investment industry where large brokers farm out their orders to smaller dealers for execution because they cannot handle the volume of orders they receive on their own. Sometimes, dealers pay a premium for having orders distributed to them, usually a few pennies on each trade. This is not always legal, and there may be restrictions on when dealers can make payments for order flow with the goal of directing more orders in their direction.
When a person signs up at a brokerage, the broker agrees to execute orders in the market on direction from the client or through orders from a client's financial adviser. Brokers can handle huge numbers of trades every day as they work with clients of various sizes and levels of interest in the market. To make sure that orders are executed in a timely fashion, they can be distributed to other dealers.
Once the order has been successfully completed, the client can be notified, if desired, that the deal is done. The details are recorded by both the dealer and the broker to make sure there is a clear paper trail tracking the purchase or sale of securities and documenting the price, number of securities involved, and other details. In the event of a dispute, these details can be consulted to determine the facts of the matter and provide a resolution.
By distributing orders through order flow, brokers can sometimes access better deals, as dealers can package multiple orders for the same security and execute them all at once. When payment for order flow is allowed, brokers can make money on each transaction in addition to the fees they already earn for handling financial accounts on behalf of their clients. While an individual trade may not yield very much money, in the long term, these fees can add up substantially.
If a broker accepts payments for order flow, this must be disclosed to clients when they sign up for new accounts. Information about payments received should be provided. Failure to do this can subject people to legal penalties if it is reported to regulatory agencies like the Securities and Exchange Commission. In some regions, there are concerns that payments for order flow could compromise brokers or dealers, as brokers will preferentially send orders to dealers who will pay, rather than selecting the best person to leave an order with.
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