What is a directed order flow?
A customer may give specific instructions on the security he wants to buy or sell. He may specifically say a particular exchange or venue of execution for his orders. These kinds of instructions happen, and the situation is called directed order flow. As we mentioned, the reason why it was named as such may be apparent. It is because the client gives directed orders about the route of execution. It may be because the client has a bad experience from another exchange or simply prefers one exchange. This preferred exchange may have available execution prices which are better than the others. Hence, it is more beneficial to trade stocks or securities there. Typical retail investors usually do not mind the exchange a lot. However, it is a significant factor for other active investors.
Different traders, different preferences
As we have mentioned, some do not make the execution venue a big deal. We call these clients “non-directed orders.” They let their brokers decide where the order will be executed, and any exchange will do. SEC thought that since there are non-directed orders, they need to be protected from brokers who might use them for their benefit. Hence, SEC made Rule 11Ac1-6, which was now replaced with Rule 606, stating that all broker-dealers should submit quarterly reports that will show all their order routing records. Nowadays, directed order flows are not too beneficial because trading venues have almost similar service levels. Also, ECNs somehow eliminated the arbitrage opportunities that one can get from directed orders.
Trading nowadays is not like how it used to be anymore.
On the other hand, some say that directed order selection advantages might come back because of massive algorithm use, machine learning, robotic style selection or preferred trading, similar strategies driven by quantities, and the like. But if we observe how trading works nowadays, we can say that it does not focus much on direction or non-direction anymore. Instead, much importance is given to the aggressiveness and passiveness of the order. This is the technique that many say is for the best execution for trade orders. Passive orders tend to add more liquidity to the market. On the other hand, aggressive orders placed in the order book of trading venues can suck the liquidity of a market.
Why is there a criticism of brokers who accept payment on directed flow orders?
They say that it does not break any rule, but many still find it unethical. Hence, the practice remains controversial. Firms that direct orders to different venues for execution receives payment for order flow. It is a minimal payment, and it is usually a penny per share. The compensation nature is significant. The broker receives fees from a third party. Sometimes, the client may not even be aware. So, this can become a conflict of interest. Hence, others criticize this practice. On a brighter note, brokers have become more transparent about this kind of practice today. In fact, the brokerage firm should inform you if it receives payment from other parties for sending orders. The SEC requires this every time an account is opened and on an annual basis. The firm is responsible for informing a client about every payment it receives involving an order.