What is payment for order flow?

In short: “Payment for order flow is the way your broker will outsource his order fullfillment. They usually have a prearranged agreement with a market makers who will execute the order for them.”

market depth chart / bid ask spread

The new buzz word for 2021 is “payment for order flow” whereby some brokers receive payments from market makers (dealers) for routing trades to them. The main target in this story is Robin Hood. Especially now that the Gamestop saga is unfolding. Robin Hood is the broker that a lot of milenial stay-at-home traders use. They do it because Robin Hood lets them trade for free. But as your grandfather already taught you. Nothing is really for free. (actually he said only the sun comes up for free). Or as more new FB terms. “If a product is for free, You are the product!!! ” Officially they are called retail traders. The majority of retail trading is not done on exchanges, it is done by market makers that “internalize” the trades.

In the wake of the GameStop short squeeze, payment for order flow—the practice of market makers paying brokers to execute customer orders—has fueled no small amount of debate: Is it a tactic deployed by large capital markets institutions to steal money from the less informed, or is it an enabler of low cost, highly efficient stock trading for all?

Here’s how it works. Let’s say you want to buy 100 shares of Tesla. When you push the button on a trade, you have given your broker an order to buy 100 shares of Tesla at the market price. Your broker will usually have a prearranged agreement with market makers who will compete for the order flow. The bigger market makers include Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma and UBS. Most people have heard of the New York Stock Exchange and Nasdaq, but there are dozens of other venues in total that can “trade” stocks.

Virtu CEO Doug Cifu said his firm competes fiercely for that order flow:  “Most of the brokers have a ‘routing wheel,’ and within that wheel, they will send client orders to the market makers based on the amount of price improvement they have provided,” he said. The rate of payment for order flow varies from broker to broker, Cifu noted, but is usually fixed within the broker. A broker may charge 10 cents per 100 shares, for example. Others may charge more, some nothing. The key point, Cifu says, is that Virtu and the other firms must meet best execution obligations, which will usually include price improvement.

Let’s go back to that Tesla trade, to buy 100 shares. Suppose the bid (what a buyer was willing to pay) was $792.80, the ask (what a seller was willing to sell for) was $793.20. The midpoint is $793. Cifu said it would be typical to offer some kind of price improvement, perhaps $792.90. “It’s a riskless trade,” Cifu insisted. “As soon as the price hits us, we guarantee the broker they are getting the best price.” Cifu also noted that in the last several decades bid-ask spreads have declined, execution speed has improved, and fees have declined, all as a result of technological innovation.

Still, many market observers have been critical of payment for order flow, among them Better Markets, a nonprofit organization that seeks to promote public interest in the financial markets.

In a paper distributed prior to the Robinhood-GameStop hearings, Better Markets claimed payment for order flow “is widespread and causes an inevitable conflict-of-interest between the retail broker-dealer’s duties to seek best execution for its customers and its duties to shareholders and others to maximize revenues. … These execution costs can outweigh the benefits to retail investors associated with so-called ‘commission-free trading. Cifu says there is no data to support those assertions.

“At a minimum, you are getting the same price you would get if you went to an exchange,” he said.  “Every single broker is routing based on price improvement and a best execution obligation.” Still, the idea persists that if market makers are making money, they must be taking it from retail investors. The exchanges have a different concern: retail trader orders that are routed to relatively “dark” venues like broker-dealers without interacting with public orders from the exchanges.“Growing retail investor interest is a welcome development,” said Michael Blaugrund, COO of the NYSE.   “But all of this trading in private dark venues means liquidity is becoming less accessible for institutional investors and the price discovery process is becoming degraded.

When things go according to plan, market makers receive more and more orders and can often trade “inside” the published bid-ask spread—actually improving the price you receive compared to the best quoted price on any exchange. Filling your market buy order for Facebook at $268.42 instead of routing to an exchange that would fill it at $268.47 would represent a five cent price improvement over the best offer, which the market maker can sometimes do by matching against an offsetting order now or against an offsetting order later.

Without routing to an “internalizer” or “wholesaler,” retail investors will likely face bigger spreads, less liquidity, and higher fees as everything would get routed to a costly exchange or alternative trading system when market makers couldn’t provide the better prices to retail.

As with many areas of capital markets that are not clear at first glance, trying to “fix” something based on a misunderstanding of how it works…will make it worse. More liquidity in our public markets is a win for everyone, and the complex system that we have today provides more liquidity than at any time in history—especially retail investors. It may be imperfect, but it’s extraordinarily effective.

Over the Wiseguy

Stock trader, Owner and Administrator of "the-wiseguy.com". . . "TA is like surfing. You don't have to know a lot about het physics of tides to catch a good wave. You just have to be able to sense when it's happening and have the drive to act at the right time"

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