PFOF, or payment for order flow, is one of the most often used words in trading, especially in traditional crypto trading marketplaces. Brokers or exchanges offer customer orders to market makers or other third parties and then get a return.
While PFOF is accepted as normal practice, the effects on trading strategies and costs can be huge, particularly for those who trade daily. This guide will explain the impact of PFOF on crypto traders and how to deal with it.
What is Crypto Payment for Order Flow (PFOF)?
PFOF is a term that started in the ordinary finance market, like stock trading, but has also extended to crypto trading. It’s a technique where market participants pay brokers or exchanges to receive their orders.
Although this strategy allows platforms to provide zero commission services for their buyers, traders may suffer other forms of commission. Traders may suffer because of higher trading prices than they would have obtained on the open market.
This disparity can mount over time, particularly for regular traders.
How It Affects Crypto Trading Costs
PFOF brings along hidden costs that the traders do not see at the onset. Such costs are often associated with a slight increase in price or some delay in terms of execution.
High-Frequency Trading (HFT)
Plenty of trades are executed using this strategy to profit from the minimal price movements on the market. There can be delays, even in milliseconds, which can make the strategy less efficient.
When the effective price of the trade is greater than the initial intended price for executing the trade, a slippage has occurred. These small inefficiencies can have a cumulative negative effect on traders.
Arbitrage Trading
Arbitrage traders buy and sell securities to profit from price differences in different exchanges or markets. With the implementation of PFOF, this is not always the case; the expected price is not the price realized in orders routed through market makers.
Moreover, a definite price guarantee is almost impossible. Thus, it becomes harder for arbitrage traders to benefit from these small price differences, lowering the efficiency of this strategy.
Day Trading and Scalping
Day trading, or scalping, is characterized by taking more than one trade in a single day to profit from minute price changes. The PFOF strategy enables a slight raise in the execution price for every trade, limiting the average profit per trade made by day traders.
The difference in profit per trade is marginal, but when considered daily, it can be a big mushroom that will waste returns for the day.
Why is PFOF Controversial in Crypto Markets?
One of the most contentious issues regarding PFOF is the lack of transparency. Most retail traders are oblivious that their trades are often sent to third parties to fill, who sometimes cannot get the best price for the trade.
However, such an arrangement favors the market makers, who make money out of the difference in buying and selling prices. There is also the issue of brokers who profit by directing orders to certain market makers and are paid for it.
Opponents point out that this encourages brokers to put their interests in earning maximum money ahead of the customers’ interests in getting the best deal for their orders. A recent example of such a scenario was the 2021 GameStop trading rush.
Trading was on Robinhood barred to protect market-maker relationships.
Regulatory Response
PFOF has come under regulators’ radar in many jurisdictions, especially in the US and Europe. The two regions are contemplating ways to either enhance the practice’s accountability or do away with it altogether.
To this end, the US Securities and Exchange Commission (US) has developed various rules on PFOF. One such rule is that the client’s interests must take precedence over the brokers’ interests.
On the contrary, the European Union has set plans to eliminate PFOF from the market by the year 2026. However, many US-based commentators endorsed the initiative, arguing that it forces brokers to provide commission-free trading, which increases the participation of retail traders in the markets.
They added that the absence of PFOF practice would force brokers to revert to charging commissions, thus increasing the burden on small investors who are trying to enter the market. Nevertheless, the argument hinges on whether the advantages of zero commission trading are worth the amendment, given the supplementary costs posed by POFM.
How Can Traders Minimize the Effects of PFOF?
Although PFOF is inevitable on certain platforms, there are ways to decrease its negative influence on trading costs.
Trade on Exchanges with Transparent Fees
Some exchanges like Binance and Kraken focus more on the market and have no hidden fees. Thus, users benefit from knowing exactly what fees they will incur to ensure they are getting the best price possible. However, many exchanges offer little info about PFOF.
Switch to Decentralized Exchanges (DEXs)
The Uniswap and SushiSwap exchanges are termed DEXs since they run on blockchain technology. This technology makes it possible for two users to trade with each other without the need for an intermediary.
P2P trading eliminates the requirement to pay for an ennobled order flow, which leads to better prices. However, traders should note that there are other costs (like gas fees) that increase using DEXs.
Implement Over-the-Counter (OTC) Trading
OTC trading is also an option for traders who mostly trade in lots. OTC desks, for example, provide special pricing for large orders, and it is mostly a trader-and-customer mode of dealing that’s preoccupied with the best possible cost. This eliminates the problems of PFOF and, in fact, benefits high-end traders in terms of costs.
Conclusion
Payment for Order Flow gives platforms a means to offer commission-free trading. However, it can also bring hidden expenses that affect crypto traders—especially those who utilize high-frequency, arbitrage, or day trading techniques.
Although PFOF might not completely disappear, traders can lessen its influence in various ways. They can select transparent platforms, move to distributed exchanges, or work with brokers that depend less on PFOF.
