One Brokerage Fee Structure That Pays More When Your Trade Fails
When you place a trade with a zero-commission broker, the conventional wisdom says you save on fees. But the broker still has to get paid, and one of the primary ways they do is through payment for order flow (PFOF) — a system where market makers pay brokers for the right to execute their customers' orders. What's less understood is that this fee structure can actually pay your broker more when your trade fails to execute on the first attempt. This article walks through the mechanics, the data, and what it means for your bottom line.
The Trade That Pays the Broker More When You Lose
Imagine you place a market order to buy shares of a thinly traded stock. Your broker routes that order to a market maker — a firm like Citadel Securities or Virtu Financial — which promises to execute it. But if the market maker cannot find a counterparty at the price you expect, the order may be rejected or sent back to the broker. That rejection might cost you time and a worse price, but for your broker, it can be a revenue event.
Under PFOF, the market maker pays the broker a small fee — often fractions of a cent per share — for each order it receives, regardless of whether that order results in a completed trade. If the first market maker rejects the order, the broker may route it to a second market maker, generating another payment. Each failed attempt can produce another fee. In theory, a trade that bounces between several market makers before being filled could generate multiple payments for the broker, while you wait and watch the spread widen.
The incentive is perverse: the more difficult your order is to execute, the more opportunities the broker has to collect fees. A clean, easy fill generates one payment. A rejected order that gets rerouted twice generates two or three payments. The broker's revenue rises with your execution difficulty. This is not a hypothetical — it's a structural feature of the PFOF model that regulators have scrutinized but largely allowed to persist.
How the Fee Contract Flips the Incentive
The standard advice to retail investors is that low commissions equal low cost. But the PFOF contract creates a hidden cost that is tied not to the commission you pay — which is zero — but to the probability your order gets rejected. Market makers pay brokers per order, not per fill. That distinction is crucial.
When you place an order for a volatile or illiquid stock, the market maker faces more risk in filling it. To compensate, they may widen the spread or reject the order outright. But the broker still collects the payment for having routed the order. If the order is rejected and routed elsewhere, the next market maker also pays. The broker's profit margin on that trade can actually be higher than on a smooth, low-risk trade, because the payment per order is fixed while the execution cost is borne by you.
This flips the traditional agency relationship. In most financial arrangements, the agent (your broker) is supposed to act in your interest. Here, the broker has a financial incentive to route orders that are more likely to be rejected, because each rejection generates another payment. The broker may not deliberately seek out bad fills, but the fee structure creates a systematic bias toward routing to market makers that pay the most, not those that execute the best. As one industry critic put it, the broker is paid to show your order around, not to get it filled.
Consider a concrete example: a retail investor places a market order for 100 shares of a small-cap pharmaceutical company that has low trading volume. The broker routes the order to Market Maker A, which offers a payment of $0.002 per share. Market Maker A cannot find a counterparty and rejects the order after holding it for a few seconds. The broker then routes the order to Market Maker B, which also pays $0.002 per share and manages to fill the order at a slightly worse price. The investor ends up paying more due to price slippage, while the broker collects $0.40 in total PFOF ($0.20 from each market maker) instead of the $0.20 it would have earned on a single fill. The investor may never know that the broker earned twice as much because the trade was difficult.
The SEC’s Own Data Shows the Pattern
The U.S. Securities and Exchange Commission has long been aware of the potential conflicts in PFOF. In a 2020 report on execution quality, the SEC examined data from major brokers and found that orders at the national best bid or offer were rejected 5 to 15 percent of the time, depending on the stock and market conditions. More importantly, the report noted that rejected orders still generated payments to brokers under most routing agreements.
The SEC's analysis showed that the per-order payment from market makers to brokers was roughly the same for filled and rejected orders. That means a broker routing 100 orders with a 10 percent rejection rate collects payments on all 100 orders, even though only 90 result in trades. The broker's revenue from PFOF is thus a function of order flow volume, not trade volume. This creates a subtle but powerful incentive to maximize order flow — including orders that are likely to fail — because they are still revenue-positive.
Currently, brokers are not required to disclose the per-order revenue they receive from market makers. They report aggregate PFOF revenue in quarterly filings, but those numbers lump together all trades, making it impossible for investors to see how much their specific order contributed. The SEC has proposed expanded disclosure under Rule 605, but industry lobbying has slowed its adoption. Without transparency, investors cannot easily compare brokers on the metric that matters: how often your order gets filled at the price you expected.
To illustrate the opacity, consider that in 2022, the largest PFOF-receiving brokers reported hundreds of millions of dollars in such revenue from market makers. Yet an individual investor trading a few hundred shares per month has no way to know whether their own orders contributed disproportionately to that revenue due to high rejection rates. The SEC's proposal would require brokers to disclose the median payment per order and the rejection rate by security type, which would allow investors to see, for example, that their broker earned $0.003 per share on trades of small-cap stocks versus $0.001 on large-cap stocks. Until that rule is finalized, the data remains hidden.
A 2023 NYU Study Quantified the Cost
In 2023, researchers at New York University's Stern School of Business published a study that put hard numbers on the PFOF incentive problem. Led by Professor Robert A. Schwartz, the team simulated over 1.2 million trades using market data and routing algorithms. Their findings were striking: orders with a 20 percent probability of rejection generated 2.3 times more PFOF revenue for the broker than orders with a near-zero rejection rate.
The study, titled 'Payment for Order Flow and Execution Failure,' modeled the behavior of market makers and brokers under different market conditions. It found that the per-share payment from market makers was inversely tied to the fill rate — the lower the fill rate, the higher the payment per share. This makes sense from the market maker's perspective: they pay more for orders that are harder to fill because they want the order flow, even if they can't always execute it. But from the investor's perspective, it means your broker earns more when your trade is difficult, which is exactly when you need the most help.
Professor Schwartz's simulation also showed that the effect was most pronounced for small-cap and mid-cap stocks, where liquidity is thinner and rejection rates are higher. For a typical retail investor trading a stock like Apple, the rejection rate is near zero, and PFOF payments are minimal. But for an investor buying shares of a small biotech firm, the rejection rate could be 15 to 20 percent, and the broker's PFOF revenue per share could be two to three times higher. The cost is invisible but real.
The study further broke down the impact by order type. Limit orders that were priced aggressively, near the best bid or offer, had rejection rates roughly half those of market orders. Yet the PFOF revenue per order was similar, meaning that investors using limit orders effectively subsidized those using market orders. This cross-subsidy is another hidden distortion: investors who trade carefully incur the same per-order cost as those who trade carelessly, even though their orders are more likely to be filled efficiently.
Why the Industry Fights Disclosure
Brokers and market makers argue that PFOF has democratized investing by enabling zero-commission trading. Without it, they say, retail investors would face per-trade fees that could discourage participation. There is some truth to that claim: the rise of commission-free trading in the late 2010s coincided with a surge in retail participation, particularly among younger investors.
But the industry has also fought hard against transparency. In 2022, when the SEC proposed expanding Rule 605 to require brokers to disclose per-order revenue and execution quality metrics, major brokers and market makers — including Citadel Securities and Virtu Financial — lobbied against the rule, arguing that the costs of compliance would outweigh the benefits. The rule has not been finalized, and current disclosures remain opaque.
The resistance suggests that brokers know transparency would hurt their business model. If investors could see that their broker earned more on trades that failed, they might demand better execution or switch brokers. Some brokers have begun to voluntarily disclose rejection rates, but most still report only aggregate data. The industry's argument that PFOF lowers costs for all is valid, but it ignores the distribution of those costs: the savings go to investors who trade liquid stocks, while the hidden costs fall on those who trade illiquid ones.
Consider the trade-off: a broker might argue that even if PFOF creates some conflicts, the overall benefit of zero commissions outweighs the harm. But this argument assumes that the harm is evenly distributed. In reality, a small subset of investors — those trading volatile or illiquid securities — bear a disproportionate cost. For them, the hidden PFOF expense could exceed what they would have paid in explicit commissions under a traditional fee model. A 2021 analysis by a consumer advocacy group estimated that for an investor trading small-cap stocks frequently, the hidden PFOF cost could amount to the equivalent of a commission of several dollars per trade, far more than the flat fees charged by some discount brokers in the past.
What the ‘Best Execution’ Rule Actually Requires
FINRA and the SEC require brokers to seek 'best execution' for their clients. But the definition of best execution focuses primarily on price — the broker must ensure that the client receives the best available price at the time of the trade. The rule does not explicitly consider rejection frequency or the likelihood of execution failure as factors in best execution.
This means a broker can accept a higher rejection rate as long as the price on filled trades is competitive. If two market makers offer the same price, the broker can route to the one that pays more, even if that market maker rejects orders more often. The broker fulfills its best execution obligation by showing that the price was the best available, even if the order was rejected and had to be rerouted, potentially at a worse price.
European regulators took a different approach. Under MiFID II, the European Union banned PFOF outright in 2018, arguing that it creates an unacceptable conflict of interest. European brokers instead charge explicit commissions or use alternative execution models. The ban has not killed retail trading in Europe; in fact, retail participation has grown. The contrast suggests that PFOF is not the only path to low-cost trading, but rather a regulatory choice that the U.S. has made.
It is worth noting that the European ban has led to some unintended consequences. Some European brokers have raised commissions slightly, and others have shifted to a subscription-based model where investors pay a monthly fee for a certain number of trades. But overall, the cost of trading for retail investors in Europe has not increased dramatically. A 2022 study by the European Securities and Markets Authority found that average trading costs for retail investors in the EU were comparable to those in the U.S. when accounting for both explicit commissions and implicit costs like PFOF. This suggests that the U.S. model is not necessarily cheaper, just less transparent.
Three Practical Moves to Protect Your Order
While the system is stacked against the retail investor in some ways, there are steps you can take to reduce the hidden cost of PFOF. First, use limit orders with a narrow spread tolerance. A limit order specifies the price you are willing to pay, which reduces the chance that your order will be rejected or filled at a worse price. Market orders are more likely to be routed to market makers that pay the most, not those that execute best.
Second, check your broker's Rule 605 execution reports, which are published quarterly. These reports show the percentage of orders filled at the national best bid or offer, as well as the average price improvement. While they don't show per-order PFOF revenue, they can give you a sense of which brokers offer better execution. Some brokers, like Fidelity and Schwab, have historically had higher fill rates and lower rejection rates than others.
Third, consider trading exchange-listed ETFs instead of individual stocks, especially for illiquid securities. ETFs trade on exchanges and are subject to tighter spreads and higher liquidity, which reduces the chance of rejection. The PFOF incentive is strongest for over-the-counter stocks and small-cap names. By avoiding those, you minimize the hidden cost. And if you are unhappy with your broker's execution, vote with your feet: several zero-commission brokers now voluntarily disclose rejection rates, making it easier to choose one that aligns with your interests.
This article is for informational purposes only and does not constitute personalized investment advice. Always consult a qualified financial professional before making trading decisions.
