Pay For Flow

Buying and selling stocks costs money, no matter how free the fees appears to be. Apps like Robinhood that hide the true costs from investors are slyly selling out their customers to the highest bidder. Their business model depends on the kickbacks they receive, often from the very predators that prey on their own customers. Various hedge funds and proprietary trading desks are willing to pay for the opportunity to attract small investors into their dark pools. These large traders profit from the retail crowd's lack of sophistication. Even the smartest individual investor cannot match the speed and market power of a trading algorithm that exploits every arbitrage method in the book (e.g. scalping, front running, market-taker fees).

The practice of delivering brokerage clients to predatory traders is called Payment-For-Order-Flow. Contrary to Robinhood's marketing spin, its widespread use on Wall Street is not democratizing finance, it's exposing the inherent conflicts of interest within the existing stock market structure.

Payment For Order Flow

Fun Fact: Citadel is now a large player in the payment-for-order-flow business. It's funny because when the concept of monetizing the exhaust from retail clients was first being floated, Citadel was strongly opposed. Here's what the company wrote to the SEC in 2004¹:

• "[P]ayment for order flow arrangements lack transparency" [and is] "anti-competitive".

• [It] "creates an obvious and substantial conflict of interest between broker-dealers and their customers".

• [The SEC should] "ban payment for order flow altogether".

We couldn't agree more with 2004-Citadel!

History

The best part is that the practice of payment-for-order-flow was pioneered by Bernie Madoff². That's the same Bernie Madoff who was the perpetrator of the largest Ponzi scheme ever (with investor losses reported to be upwards of $65 billion). Before being a convicted fraudster, he led the National Association of Securities Dealers (NASD, now called FINRA) and thought that selling out brokerage clients was the best way to achieve an efficient market.

Here are some more details on the practice from a variety of different sources, with multiple viewpoints (not just from left-wing-yet-clueless commentators like Jon Stewart that spin everything into a joke):

As of 2010, every American stockbroker and all the online brokers effectively auctioned their customers’ stock market orders. The online broker TD Ameritrade, for example, was paid hundreds of millions of dollars each year to send their orders to a high-frequency trading firm called Citadel, which executed the orders on their behalf. […] The bigger Charles Schwab, whose order flow was even more valuable than TD Ameritrade’s, had sold its flow to UBS back in 2005, in an eight-year deal, for only $285 million. (UBS charged the high-frequency trading firm Citadel some undisclosed sum to execute Schwab’s trades.)

Source: Michael Lewis. Flash boys: a Wall Street revolt. WW Norton & Company, 2014. [B026]

Ameritrade had a deal to send most of its orders to Knight Securities, a computer-savvy broker dealer based in Jersey City. Knight paid Ameritrade for the orders, in return promising to provide a good execution for the trades.

Source: Scott Patterson. Dark pools: The rise of the machine traders and the rigging of the US stock market. Crown Business, 2013. [B082]

There is a long standing practice of payment for order flow from broker-dealers in the US. Through this mechanism the broker dealer gets the choice to either receive a small price improvement on an order or re-route it to public markets. By doing so, they can trade at prices forbidden on lit markets because they don’t have to display an order whose price would be outlawed, they simply accept an economically insignificant price improvement and thanks to this have the power to step ahead of a public limit order for small to no cost.

Source: Charles-Albert Lehalle and Sophie Laruelle. Market microstructure in practice. 2013. [B073]

[Contractual Market Markers] (CMMs) in U.S. equities generally are required to fill 100 percent of “small” orders on an automated basis (this is aptly known as autofill). So, for example, a typical investor in U.S. equities has an account with some online broker. This investor decides to buy, say, 200 shares of XYZ as a market order. The CMM has agreed with the broker that it will sell 200 shares of XYZ to this customer at whatever the prevailing market’s best offer is. But interestingly, neither the customer’s order to buy nor the CMM’s taking the other side of that trade ever goes into the exchange’s limit order book. […] The CMM, by virtue of having agreed to this contractual relationship with the broker, gains an advantage that supersedes even the fastest traders. In effect, it doesn’t even need to post bids and offers because it passively takes the other side of all customer order flow as it comes in. This happens in the reverse sequence to what happens in a normal market situation: Generally a passive order is resting in the limit order book, and an active order comes into the market later and takes the liquidity offered by the passive order. In this case, the active order to buy comes to the CMM, and the CMM uses the prevailing best offer from the exchanges to fill the active order. […] The CMM is piggybacking on whatever the prevailing best offer was at the time the CMM elected to fill the customer order. All that said, so far, it is not at all obvious that the customer is any worse off by virtue of his broker having established this contractual relationship.

Trading passively is not necessarily a highly profitable activity (especially before the incentives provided by some exchanges for providing liquidity), because of the problem of adverse selection. However, when facing off against retail order flow, a passive participant enjoys the most favorable selection possible. Retail order flow generally consists of a large number of small orders, and the aggregate of these orders on a given name is usually a fairly small net quantity. This means that there is unlikely to be any significant price impact, which is another important determinant of the level of adverse selection. For larger orders, CMMs generally have the right to act as an agent of the customer, trying to get the order filled at market, without taking the whole order for itself. So, if the customer wants to buy 10,000 shares of XYZ, the market maker acts on behalf of the customer in attempting to get the order filled. However, here, a perverse incentive may exist.

Source: Rishi K. Narang. Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading. John Wiley & Sons, 2013. [B080]

There are reasons why brokerage firms offer $8 trades to retail investors, when so often that fee doesn’t cover costs. [...] Money that used to be made mostly through commissions is now made through trading around that order flow. For example, your online broker likely sells your order to a “market maker,” rather than routing it to an exchange. That market maker is an HFT expert and gets first crack at deciding whether to be on the other side of your order or route it to an exchange. [...] Armed with up-to-date information on all the retail order flow that they buy, its algorithm decides whether your retail order is “dumb” or “informed” and acts accordingly. At times, HFT has a parasite/host relationship with investors. HFT works well only when there are sufficient hosts in the pool upon which to feed. When the hosts dwindle, due to lack of confidence in the system, and funds flow out of equities, HFT firms suffer.

When your execution receives a sub-penny price improvement, it is probably because your order was sold by your broker to an internalizer or routed to a dark pool that has intercepted your order before it could go to the displayed market and receive an even better price. Most online brokers use a smart order router to execute your trades. The router is smart for them because they can maximize their payment for order flow, but it is not necessarily smart for you. [...] Your order will probably get filled when the market is about to move against you.

Source: Sal Arnuk and Joseph Saluzzi. Broken markets: How high frequency trading and predatory practices on Wall Street are destroying investor confidence and your portfolio. FT Press, 2012. [B083]

Footnotes

¹ : See "Comment on Release No. 34-49175: Competitive Developments In The Options Market", as reported by MarketWatch.

² : See Payment for Order Flow: Bernie Madoff's golden goose. Lendit Fintech News, Oct. 4, 2021. Confirmed via SFL, the Problem With Jon Stewart and [B082].