Payment for order flow is when venues pay money to brokerages for routing retail buy and sell orders to them rather than directly to the stock exchange. Retail brokers could route every order straight to an exchange but they typically route them to market makers because they can provide the highest price improvements.
There is debate over whether the practice promotes inexpensive, efficient trading for all or if it is a tactic large capital market institutions use to generate money from less-informed investors. Much of the debate is a result of misunderstandings about the complexity of the stock markets and the forces driving them.
The investor gets the best price
A sell order is usually filled immediately at the best price. How does a market maker generate money if the investor gets the best price? The business model of market makers relies on their ability to process the same number of buys as sells. This enables them to make a profit over time.
There is a risk of trades being imbalanced when there are more sells than buys. The compensation market makers receive is because they are willing to take this risk. As long as they are buying and selling equally, they should make a profit.
A balancing act
Market makers that get more and more orders can trade within the published bid-ask spread and this improves the price investors receive in comparison with the best prices quoted on any exchange.
If the price “runs away” on one side of the trade, market makers have to “find” shares later at a higher price and so they expose themselves to more risk. They usually have risk models so they don’t allow themselves to become too imbalanced.
A need for speed
Market makers must make quick decisions when they quote prices if they want to stay in the game. In other words, what they have to do is very competitive and difficult. If they don’t keep their offers current when the market moves, they will lose money.
Making a market
If you want to sell a certain number of shares in a particular stock at a certain time, the chances that someone else wants to buy the exact number of the stock at that very second are slim to none.
Market makers do not bet on the direction of the market. They bridge the gap in time between when you want to sell your shares and someone else wants to buy them. They basically transfer risk between buyers and sellers.
As compensation for holding the position they bought from you using their own capital, they earn a small spread. Buyers and sellers need the liquidity this offers. An article on the daytradingz.com website explains the payment for order flow concept and how it works.
What the critics have to say
The majority of trades retail brokers execute have better prices than those on markets. Retail money is a good mix of buy and sell orders. Small amounts per order compared to large institutional flows increase the odds that a market maker will receive offsetting orders during the day. This makes it economical for them to offer the prices they do.
Critics argue that market makers withhold liquidity from exchanges but the data to support this is missing. There are hundreds of venues where securities are traded and exchanges themselves earn profits.
The number of trading venues as well as the pricing pressures placed on market makers works in favor of investors receiving good prices. Retail investors would suffer if they all had to trade on exchanges and couldn’t benefit from price improvements.