By Michael Scott
Payment for Order Flow (PFOF) in Crypto
PFOF originated from traditional finance, where stock brokers routed trades to market makers for a kickback. It has now found its way into the crypto world.
Brokers benefit from the payments since it is an additional revenue stream, but traders do not see the immediate cost. This is because, despite not paying a direct fee, the market marker might not give the best price, subtly impacting the overall trade cost.
This is how PFOF functions behind the scenes: The broker is paid by the market maker, while one ends up paying slightly more for the trade than anticipated, even in the absence of a visible commission fee. On a more transparent exchange, an order is executed directly at the present market price.
How PFOF Affects Crypto Traders
PFOF tends to have the most significant effect on certain crypto trading strategies, particularly those that depend on minimal price variations and precise execution.
Examples of affected strategies are:
- High-frequency trading (HFT): Traders depend on quick execution to leverage small price shifts. With PFOF, orders are routed via a market marker, which can lead to small delays or less-than-optimal prices.
- Arbitrage trading: Price variations between various exchanges or markets are exploited by traders, enabling them to make money. For example, PFOF can interfere when a trader anticipates purchasing Bitcoin at $60000 in one exchange and selling it in another exchange for $60100.
Routing can result in the trader getting a slightly worse price instead of the anticipated one, reducing the arbitrage opportunity.
- Day trading and scalping: Day traders who depend on frequent trades and small price shifts are sensitive to PFOF. In case a person makes several trades daily, paying even a slightly higher price on every trade can considerably affect daily returns.
Day traders seek to capture small price variations, and SPOF can erode the gains over time.
PFOF’s Controversy in Crypto Markets
PFOF’s potential conflict of interest is a major controversy. By getting payments from market makers for routing trades, brokers can prioritize profits over acquiring the best price for users.
Further, critics note that the PFOF model lacks transparency. In most cases, traders are not aware that their orders are being routed to third parties who might not offer the best possible price.
In spite of such issues, not all people agree that banning PFOF would address the problems. According to some experts, PFOF has democratized trading by permitting platforms to offer commission-free trades, improving the accessibility of trade to everyday persons.
The debate hinges on whether the cost of hidden fees and possible conflicts of interest outweigh the advantages of zero-commission trading. Despite potential regulation, it remains uncertain if banning PFOF would improve traders’ outcomes.
How to Reduce PFOF Fees in Crypto Trading
Examples of practical tips for traders who want more control over their trading costs include:
Using transparent exchanges
This entails trading on platforms that are truthful regarding their fee structures. Exchanges like Kraken or Binance execute trades without routing them via third-party market makers.
Switching to decentralized exchanges
Decentralized exchanges (DEXs) are a perfect option to avoid PFOF fully. They are developed on smart contracts to facilitate trades among peers and do not depend on centralized intermediaries such as market markers.
Choosing brokers with lower PFOF dependency
One can pick centralized exchanges or brokers that do not profoundly depend on PFOF as their main revenue stream.
Considering over-the-counter (OTC) trading for larger orders
OTC trading desks can be a perfect alternative for traders dealing with larger amounts. OTC trading desks are negotiated directly between purchasers and sellers, focusing on finding the most suitable price for large orders.
Being informed concerning fee disclosures
One must know how their broker or exchange earns money. For instance, SEC Rule 606 mandates brokers to reveal their order routing practices and the amount gained from PFOF.
The Future of PFOF in Crypto Trading
In the coming years, more innovation will happen in trading models as platforms seek ways to balance fairness and profitability. Traders must remain informed about the impact of the changes on costs and strategies.