Knowing that immutability in order flow is part of our ethos, a friend of Deepwaters recently asked us our thoughts about Dflow. Dflow is creating an open, decentralized marketplace for order flow. It guarantees the “best available price.” That claim - the best available price - is where arguments in favor of payment for order flow (PFOF) start to fall apart. More on that in a moment.

Payment for order flow (or order internalization, which has almost the same effect) is very likely to be a common occurrence in crypto markets. This is because crypto markets are very loosely regulated in most jurisdictions, and exchanges can make more money when they sell order flow. Some exchanges, such as Hashflow, were effectively built entirely on this model, with pricing set solely by market makers. The current PFOF models which exist in crypto almost certainly occur primarily on centralized exchanges (we can’t be totally certain because the exchanges aren’t obligated to make that information public), are entirely opaque, and most likely prioritize profits for the exchanges and their market makers engaging in the pay-to-play PFOF schemes.

Within that reality, Dflow is providing a meaningful service. They are seeking to ensure that PFOF is implemented in what is arguably the most favorable way for traders, requiring both best execution and transparency. This is actually better than the best PFOF arrangements in TradFi, where best execution is often a contractual requirement, but there is no transparency. However, in many jurisdictions PFOF is illegal in TradFi, and no PFOF is better than any PFOF. Why is that?

The inherent problem with payment for order flow is that all of the orders which are subject to PFOF are not going to any order book. They are all being internalized.

When everyone is internalizing or selling order flow, it effectively fragments liquidity because the orders never make it to an order book. The market makers and exchanges can tell the traders that they are providing the best execution, but if the orders were to all make it to the order book that would no longer be true. Some orders would meet between the spread. Some would hit the books and narrow the spread. But with PFOF, they never get the opportunity.

The whole "PFOF is good" argument relies on you taking as fact their implicit assumption that the current state of the order book is the most liquid it could ever possibly be. Given that PFOF inherently prevents the order book from being more liquid than it is, that assumption is ridiculous.

For more words, charts, and math on the subject, we recommend this report from BestEx Research.