Payment for Order Flow

[marko]

Trying to follow the money here:

From what I understand, a brokerage (Schwab et. al.) makes money these days in spite of not getting commissions through something called Payment For Order Flow which is paid to the brokers by the Market Makers.

What I don't get is why the Market Markers are willing to pay for the opportunity to make the trade.

What's in it for them? Do they control the spread and make a few cents on the delta?

How does that work? Not that I care but when I trade a stock am I getting shortchanged by $0.00000001 cents somewhere?

 

[Dd852]

So… yeah. The market makers want to make money on the spread so they want to do the trade, and thus are willing to kick back a bit of what they make. In theory by law you shouldn’t lose out, but I think in fact a small lot will never get the tight spread a big player could negotiate. Anyway, this is a great and pretty extensive explanation https://crsreports.congress.gov/product/pdf/IF/IF11800

 

[ownyourfuture]

Most brokerage firms pay little to nothing for idle cash sitting in an account.
But like a bank, a broker can use that cash for other purposes. And they do. Brokers lend this money out and invest it, earning much higher rates than they pay their customers for it.

For example, TD Ameritrade currently offers a 0.01% APY on free cash balances in its FDIC-sweep program. The broker’s margin rates vary from 8.25% to 10.25%. That’s a huge profit margin on what the company pays for cash versus what it earns by lending it out.

Broker-dealers also earn money by charging for investment-advisory services. Fidelity customers, for example, pay anywhere from 35 basis points up to 150 basis points per year for the company’s portfolio management.

And then there’s order flow. Trading firms purchase orders from retail brokers. They in turn make money off of the bid-ask spread. So both companies make money from orders without charging any commissions.

https://www.brokerage-review.com/investing-firm/make-money/with-zero-commissions.aspx

 

[Car-Guy]

Most brokerage firms pay little to nothing for idle cash sitting in an account.
But like a bank, a broker can use that cash for other purposes. And they do. Brokers lend this money out and invest it, earning much higher rates than they pay their customers for it.

^^^^^^ This


BTW, zero commissions has created/encouraged a lot more small dollar day trades.

 

[audreyh1]

Everything you ever wanted to know about payment for order flow and who benefits: the book Flash Boys by Michael Lewis.
https://en.m.wikipedia.org/wiki/Flash_Boys

 

[SecondCor521]

Everything you ever wanted to know about payment for order flow and who benefits: the book Flash Boys by Michael Lewis.
https://en.m.wikipedia.org/wiki/Flash_Boys

Excellent book, and contains the real answer to OP's question IMHO.

The gist of the idea is that some market makers are willing to pay a little bit of real money to process a trade because they can turn around and make a lot of real money based on the information they glean about supply and demand.

Not quite front-running trades, but the ideas are similar.