What "Exactly" Does Selling Order Flow Mean?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
Explorer
Posts: 393
Joined: Thu Oct 13, 2016 7:54 pm

What "Exactly" Does Selling Order Flow Mean?

Post by Explorer » Tue Nov 19, 2019 8:47 pm

As the major brokerages quickly raced to $0 commissions, a common topic gets mentioned as one of the remaining sources of revenue for the brokerages where "they sell order flow." [the other source of revenue is lending the stocks/ETFs to short sellers, which I understand]

I am trying to understand what this means and to whom the brokerages sell order flow.

Can someone knowledgeable please explain?

Thanks,
Explorer

GrowthSeeker
Posts: 860
Joined: Tue May 15, 2018 10:14 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by GrowthSeeker » Tue Nov 19, 2019 8:57 pm

I never heard the phrase, but I think some brokerages somehow manage to buy slightly below the price you get and sell slightly higher than the price you get so that they make a little profit on each transaction, even if there is no commission. Someone surely understands what the brokerages do better than my at best partially correct understanding of it.
Just because you're paranoid doesn't mean they're NOT out to get you.

User avatar
whodidntante
Posts: 8340
Joined: Thu Jan 21, 2016 11:11 pm
Location: outside the echo chamber

Re: What "Exactly" Does Selling Order Flow Mean?

Post by whodidntante » Tue Nov 19, 2019 8:59 pm

It means that the broker receives payment from a market maker who gets first cut at your poorly informed trades. They expect to make money from filling your orders. However, this does not mean that you will get a worse price.

User avatar
Svensk Anga
Posts: 703
Joined: Sun Dec 23, 2012 5:16 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Svensk Anga » Tue Nov 19, 2019 9:02 pm


Silk McCue
Posts: 4696
Joined: Thu Feb 25, 2016 7:11 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Silk McCue » Tue Nov 19, 2019 9:06 pm

Like most topics, typing “order flow” in the Google search box provides numerous past threads. There is very little that cannot be found searching this site.

Cheers

fallingeggs
Posts: 116
Joined: Sat May 04, 2019 7:11 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by fallingeggs » Tue Nov 19, 2019 10:49 pm

It’s one of those things that are tiny for any individual investor (the profit given up is pennies on a trade, so who’s going to raise a big stink?), but adds up when there are tens of millions of them. Better off with the zero commissions for sure.

rascott
Posts: 2112
Joined: Wed Apr 15, 2015 10:53 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by rascott » Tue Nov 19, 2019 10:52 pm

It's kind of like Office Space..... fractions of a penny...... just don't screw up the decimal point.

AlohaJoe
Posts: 5396
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Re: What "Exactly" Does Selling Order Flow Mean?

Post by AlohaJoe » Wed Nov 20, 2019 12:23 am

fallingeggs wrote:
Tue Nov 19, 2019 10:49 pm
It’s one of those things that are tiny for any individual investor (the profit given up is pennies on a trade, so who’s going to raise a big stink?)
There is no profit given up at all. All brokers are required by SEC regulation to adhere to NBBO -- National Best Bid and Offer.

lazyday
Posts: 3797
Joined: Wed Mar 14, 2007 10:27 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by lazyday » Wed Nov 20, 2019 1:17 am

For execution quality overall, there is probably a difference between different brokers. For example:
Our price improvement can save investors $17.20 on average for a 1,000-share equity order, compared to the industry average of $2.89.
We are the only firm to voluntarily report full price improvement savings using the Financial Information Forum (FIF) standards.
https://www.fidelity.com/trading/execut ... y/overview

ftobin
Posts: 1062
Joined: Fri Mar 20, 2009 3:28 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by ftobin » Wed Nov 20, 2019 3:22 am

AlohaJoe wrote:
Wed Nov 20, 2019 12:23 am
fallingeggs wrote:
Tue Nov 19, 2019 10:49 pm
It’s one of those things that are tiny for any individual investor (the profit given up is pennies on a trade, so who’s going to raise a big stink?)
There is no profit given up at all. All brokers are required by SEC regulation to adhere to NBBO -- National Best Bid and Offer.
If a market maker is paying for flow, that's money it can't use for price improvement on orders.

Iridium
Posts: 706
Joined: Thu May 19, 2016 10:49 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Iridium » Wed Nov 20, 2019 3:53 am

Explorer wrote:
Tue Nov 19, 2019 8:47 pm
As the major brokerages quickly raced to $0 commissions, a common topic gets mentioned as one of the remaining sources of revenue for the brokerages where "they sell order flow." [the other source of revenue is lending the stocks/ETFs to short sellers, which I understand]

I am trying to understand what this means and to whom the brokerages sell order flow.

Can someone knowledgeable please explain?

Thanks,
Explorer
Broker can get a better price for retail trades than the current market price. There are two reasons for this:
1) Stocks quote and trade on the exchange in one penny increments. For highly liquid stocks, this means that there is a queue of bids and asks waiting to be executed (sorted in order of time). Algorithmic traders may be willing to pay a small amount (less than a cent per share) to 'jump the line' if it looks like the stock is about to move.

2) One of the difficulties with being an algorithmic trader is the constant risk that your counter-party is smarter than you. Putting up an ask of $10 might make sense to your algorithm, but as soon as someone meets it, you have to ask yourself whether you got a good price for the shares...or did someone have a connection that is a millisecond faster see that a different exchange will buy those same shares for $10.01? Filling trades for brokers that deal with natural persons (and especially non-professionals) is highly attractive to algorithmic traders, because it prevents these sorts of issues (as humans, even day traders, are making decisions on longer-term principles, not trying to arbitrage milliseconds).

While brokers are required to trade at no worse than the national best bid/offer, there are many companies that are willing to offer the broker better than the NBBO on non-professional trades that the broker routes to them instead of an exchange. When the broker routes orders to such off-exchange players in return for a payment to the broker, that is selling the order flow. When the broker routes orders to such off-exchange players in return for better prices for the investor, that is price improvement. Virtually every broker does a little bit of both.

Dovahkiin
Posts: 154
Joined: Thu Jan 26, 2012 11:36 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Dovahkiin » Wed Nov 20, 2019 4:03 am

National Best Bid and Offer regulations only requires that to be computed from a select few stock exchanges - specifically NYSE, NY-ARCA, NY-MKT, and NASDAQ. Over the years several "dark pools" and other stock exchanges have popped up - BATS, IEX, etc. Let's say stock XYZ trades on all of these exchanges and you want to purchase stock XYZ at $20 a share at NBBO. However, while it's best offer is $20 in the set of [NYSE, NY-ARCA, NYMKT, NASDAQ] it may be say trading on IEX for $19.95/share. So market makers paying for order flow will buy from IEX and sell at NBBO and pocket that $0.05 spread legally.

Then NBBO regulations only apply to round lot orders. Odd lot bid/asks are not included in NBBO calculations nor are brokers required to obey NBBO for odd lot orders. So you'll get worse execution trading those 1 share trades on Robinhood and the like. Then, finally, NBBO regulations don't guarantee you actually get the listed NBBO price, it only guarantees that your round lot order is sent to that exchange explicitly unless you opt for direct routing. Then there is an issue of latency - so if a market maker knows your order was just sent to the NBBO exchange they may have a latency advantage to fill it faster or trade on that information faster.

Finally, just knowing what part of the order book is retail is huge outside NBBO issues. If you know the 1,000 round lot share limit buy order on AMD at $40 a share is retail then there are several advantages to the market makers I can think of -
1. Since it's retail it's likely a real buy order that others aren't stuffing (placing a order and immediately canceling), and so the market maker can pin that order. If the market maker can acquire shares quickly at say $39.90 then he's confident he can unload into the 1,000 retail share order at $40. If the stock is moving around a lot he knows retail orders are likely to hang for a lot longer - seconds, minutes, maybe even hours.
2. Market makers also know retail is committed to a trade once the order is place and has more price elasticty. Say retail wants to get out of AMD now as it peaked at $40 and sell pressure starts happening. Knowing that 1,000 lot sell limit order for $40 is retail is very helpful. Maybe the market maker can drop it down to $39.80, knowing the retail order will panic and cancel/replace with a new limit order at $39.80. So maybe after quoting that the market maker then quotes $39.50 right as retail is sending in the order at $39.80. Then retail panics again, maybe decides $39 straight, gets 1 lot filled from the 1 lot market maker quote, market maker lifts the rest of the order, then relists for $40, lol.
3. Retail is highly unlikely to be trading on unknown or inside information and so their orders are relatively "safer" and less adverse. If the order is coming from something that can't be verified as retail or a known hedge fund/etc then there is a lot more risk. Say a hedge fund got advance news that AMD's new chip was too dense and silicon yields were down to 15% and knows this will drop the stock to $20 and starts selling, then that is a huge risk to the market maker to take the other side on. It'd be highly unlikely for retail to know more than what the market knows as a whole.
4. Retail makes some insane plays... ever visited reddit.com/r/wallstreetbets ? I'm sure some market makers would be happy to sell inflated stock option plays to these folks. A market maker would be a lot more comfortable filling a speculative AMD $45 strike call option purchase that is far out of the money that expires this friday at $1 per contract ($0.01 share price) to someone buying 1,000 contracts if they know it's retail. They'd probably be happy to sell it naked without a hedge. If it's professional traders they'd probably start shitting their pants, sell the contract at $0.10 or $1 per share ($10-$100 per contract), and start buying a lot of underlying stock + puts to delta hedge.

Topic Author
Explorer
Posts: 393
Joined: Thu Oct 13, 2016 7:54 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Explorer » Wed Nov 20, 2019 7:14 am

Dovahkiin wrote:
Wed Nov 20, 2019 4:03 am
National Best Bid and Offer regulations only requires that to be computed from a select few stock exchanges - specifically NYSE, NY-ARCA, NY-MKT, and NASDAQ. Over the years several "dark pools" and other stock exchanges have popped up - BATS, IEX, etc. Let's say stock XYZ trades on all of these exchanges and you want to purchase stock XYZ at $20 a share at NBBO. However, while it's best offer is $20 in the set of [NYSE, NY-ARCA, NYMKT, NASDAQ] it may be say trading on IEX for $19.95/share. So market makers paying for order flow will buy from IEX and sell at NBBO and pocket that $0.05 spread legally.

Then NBBO regulations only apply to round lot orders. Odd lot bid/asks are not included in NBBO calculations nor are brokers required to obey NBBO for odd lot orders. So you'll get worse execution trading those 1 share trades on Robinhood and the like. Then, finally, NBBO regulations don't guarantee you actually get the listed NBBO price, it only guarantees that your round lot order is sent to that exchange explicitly unless you opt for direct routing. Then there is an issue of latency - so if a market maker knows your order was just sent to the NBBO exchange they may have a latency advantage to fill it faster or trade on that information faster.

Finally, just knowing what part of the order book is retail is huge outside NBBO issues. If you know the 1,000 round lot share limit buy order on AMD at $40 a share is retail then there are several advantages to the market makers I can think of -
1. Since it's retail it's likely a real buy order that others aren't stuffing (placing a order and immediately canceling), and so the market maker can pin that order. If the market maker can acquire shares quickly at say $39.90 then he's confident he can unload into the 1,000 retail share order at $40. If the stock is moving around a lot he knows retail orders are likely to hang for a lot longer - seconds, minutes, maybe even hours.
2. Market makers also know retail is committed to a trade once the order is place and has more price elasticty. Say retail wants to get out of AMD now as it peaked at $40 and sell pressure starts happening. Knowing that 1,000 lot sell limit order for $40 is retail is very helpful. Maybe the market maker can drop it down to $39.80, knowing the retail order will panic and cancel/replace with a new limit order at $39.80. So maybe after quoting that the market maker then quotes $39.50 right as retail is sending in the order at $39.80. Then retail panics again, maybe decides $39 straight, gets 1 lot filled from the 1 lot market maker quote, market maker lifts the rest of the order, then relists for $40, lol.
3. Retail is highly unlikely to be trading on unknown or inside information and so their orders are relatively "safer" and less adverse. If the order is coming from something that can't be verified as retail or a known hedge fund/etc then there is a lot more risk. Say a hedge fund got advance news that AMD's new chip was too dense and silicon yields were down to 15% and knows this will drop the stock to $20 and starts selling, then that is a huge risk to the market maker to take the other side on. It'd be highly unlikely for retail to know more than what the market knows as a whole.
4. Retail makes some insane plays... ever visited reddit.com/r/wallstreetbets ? I'm sure some market makers would be happy to sell inflated stock option plays to these folks. A market maker would be a lot more comfortable filling a speculative AMD $45 strike call option purchase that is far out of the money that expires this friday at $1 per contract ($0.01 share price) to someone buying 1,000 contracts if they know it's retail. They'd probably be happy to sell it naked without a hedge. If it's professional traders they'd probably start shitting their pants, sell the contract at $0.10 or $1 per share ($10-$100 per contract), and start buying a lot of underlying stock + puts to delta hedge.
Thank you for a very knowledgeable response. It shows some "darker" side of order flow buying. Are any of the scenarios you mention (to cheat retail) illegal by essentially front-running retail orders?

Obviously you seem to know the inside scoop.. Also, why wouldn't HFT (high frequency traders) buy orders from brokerages and then confuse the market makers on the source of orders?

Shallowpockets
Posts: 1660
Joined: Fri Nov 20, 2015 10:26 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Shallowpockets » Wed Nov 20, 2019 7:59 am

The recent post was informative and interesting. This behind the scenes view.
Yet, what is the point of this thread? Is this so BHs can look askance at the trading world and feel either justified in their avoidance of individual,stocks, or to feel angered that they may be cheated out of a penny by HFT?
Commissions, buy sell spreads, these are some of the nit pick threads we see on BHs. Parsing down the trade or your ETF or avoiding buying until such time as the perfect price comes to the fore. Or not at all. The feeling that you are being cheated by these tiny variances in selling or buying.
I am glad that as a retail investor I can now have no commissions, although i was fine with the low $4.95 before. I am glad I can see in real time the level 2 quotes as they come. I am happy that I have a trading platform at my disposal so I can see most everything. Perhaps not many here have traded in the past when costs were so much higher (as in $40 buy/sell) and the numbers were not available to you.
Worrying over the infinitesimal amounts made by traders by sell order flow or spreads is so ridiculous at most of our levels of trading.

AlohaJoe
Posts: 5396
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Re: What "Exactly" Does Selling Order Flow Mean?

Post by AlohaJoe » Wed Nov 20, 2019 8:33 am

ftobin wrote:
Wed Nov 20, 2019 3:22 am
AlohaJoe wrote:
Wed Nov 20, 2019 12:23 am
fallingeggs wrote:
Tue Nov 19, 2019 10:49 pm
It’s one of those things that are tiny for any individual investor (the profit given up is pennies on a trade, so who’s going to raise a big stink?)
There is no profit given up at all. All brokers are required by SEC regulation to adhere to NBBO -- National Best Bid and Offer.
If a market maker is paying for flow, that's money it can't use for price improvement on orders.
This is true in theory but not really in practice. You don't get better price improvement with Vanguard (who doesn't sell flow) than you do with Charles Schwab (who does sell).

Fidelity also doesn't sell order flow. On orders of 500-1,999 shares they report an average price improvement of $11.78 per order. For the same order size Schwab reports an average price improvement of $12.29. For orders of 2,000-4,999 Fidelity reports $18.32 versus $20.65 for Schwab.

lazyday
Posts: 3797
Joined: Wed Mar 14, 2007 10:27 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by lazyday » Wed Nov 20, 2019 9:20 am

Shallowpockets wrote:
Wed Nov 20, 2019 7:59 am
Worrying over the infinitesimal amounts made by traders by sell order flow or spreads is so ridiculous at most of our levels of trading.
It might not be infinitesimal for funds such as Vanguard's VSS or ishares ISCF. I generally agree that it's probably not very important, but it's one small reason I would prefer a more trustworthy broker than, say, TD Ameritrade, Etrade, or Merrill Edge.

lazyday
Posts: 3797
Joined: Wed Mar 14, 2007 10:27 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by lazyday » Wed Nov 20, 2019 9:22 am

AlohaJoe wrote:
Wed Nov 20, 2019 8:33 am
For the same order size Schwab reports an average price improvement of $12.29. For orders of 2,000-4,999 Fidelity reports $18.32 versus $20.65 for Schwab.
Thanks, I don’t recall seeing this for Schwab before.
https://www.schwab.com/public/schwab/ac ... on_quality

Fido linked in my earlier post.

AlohaJoe
Posts: 5396
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Re: What "Exactly" Does Selling Order Flow Mean?

Post by AlohaJoe » Wed Nov 20, 2019 9:29 am

lazyday wrote:
Wed Nov 20, 2019 9:22 am
AlohaJoe wrote:
Wed Nov 20, 2019 8:33 am
For the same order size Schwab reports an average price improvement of $12.29. For orders of 2,000-4,999 Fidelity reports $18.32 versus $20.65 for Schwab.
Thanks, I don’t recall seeing this for Schwab before.
https://www.schwab.com/public/schwab/ac ... on_quality

Fido linked in my earlier post.
The SEC passed a new regulation mandating quarterly reports on this for all brokerages. It was supposed to already be in effect but (some) brokerages complained that it would take longer to update their systems so it has been delayed until 2020 (I think). I assume Charles Schwab is publishing this now because of they've updated their systems and didn't see a reason to wait until 2020 to start making the information public.

Iridium
Posts: 706
Joined: Thu May 19, 2016 10:49 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Iridium » Wed Nov 20, 2019 12:18 pm

Shallowpockets wrote:
Wed Nov 20, 2019 7:59 am
The recent post was informative and interesting. This behind the scenes view.
Yet, what is the point of this thread? Is this so BHs can look askance at the trading world and feel either justified in their avoidance of individual,stocks, or to feel angered that they may be cheated out of a penny by HFT?
Commissions, buy sell spreads, these are some of the nit pick threads we see on BHs. Parsing down the trade or your ETF or avoiding buying until such time as the perfect price comes to the fore. Or not at all. The feeling that you are being cheated by these tiny variances in selling or buying.
I am glad that as a retail investor I can now have no commissions, although i was fine with the low $4.95 before. I am glad I can see in real time the level 2 quotes as they come. I am happy that I have a trading platform at my disposal so I can see most everything. Perhaps not many here have traded in the past when costs were so much higher (as in $40 buy/sell) and the numbers were not available to you.
Worrying over the infinitesimal amounts made by traders by sell order flow or spreads is so ridiculous at most of our levels of trading.
I think the actionable point is to help Bogleheads choose brokers. There is plenty of noise out in the business media that is scaremongering that brokers are reaping enormous rewards at the expense of investors. The reality is much more complicated and nuanced. The repeated point on the thread is that investors are guaranteed a price at least as good as the best visible price on the exchange (for round lots) for marketable orders and (not sure I saw this point yet) investors are guaranteed that their limit order will execute before any trades happen at a superior price. The whole off-exchange infrastructure is funded not from giving investors worse prices than the exchange, but by monetizing the fact that retail investors aren't competing in the same game as HFTs. For this, brokers get to sell order flow and investors get to enjoy price improvement. While a broker taking big fees via selling order flow might mean it is routing to markets without more than a token price improvement, it could instead mean that the broker has extremely sophisticated routing that can get both fees for flow and decent price improvement. Annoyingly, it is impossible to know what price improvement you'll get before placing the trade, so investors either have to trust averages published by the brokers or run their own experiments.

And you are absolutely right that this represents a trivial amount of money, but we are a personal finance community - of course we are going to argue down to the last penny. Just look at how many threads have been spawned by Fidelity undercutting Vanguard's fund expense ratio by 3 basis points.

ThrustVectoring
Posts: 771
Joined: Wed Jul 12, 2017 2:51 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by ThrustVectoring » Thu Nov 21, 2019 12:57 pm

The best explanation of payment for order flow I've seen here: https://www.kalzumeus.com/2019/6/26/how ... ake-money/

Tl;dr - it's between about 1 and 6 percent of a brokerage's income, pretty much a footnote. Payment for order flow exists because Goldman Sachs et al have an information edge and the capital to exploit market makers with large market-moving orders, and retail investors do not. You get better execution when the counter-party can guarantee that you're not Goldman Sachs about to run them over, and part of that gets remitted to your brokerage. The actual numbers that matter for brokerages is how much they pay in interest on idle cash.
Current portfolio: 60% VTI / 40% VXUS

Dovahkiin
Posts: 154
Joined: Thu Jan 26, 2012 11:36 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Dovahkiin » Wed Dec 18, 2019 3:51 am

Explorer wrote:
Wed Nov 20, 2019 7:14 am
Thank you for a very knowledgeable response. It shows some "darker" side of order flow buying. Are any of the scenarios you mention (to cheat retail) illegal by essentially front-running retail orders?

Obviously you seem to know the inside scoop.. Also, why wouldn't HFT (high frequency traders) buy orders from brokerages and then confuse the market makers on the source of orders?
Sorry for the late reply. I haven't logged in for a while and missed the notification. Technically it's not illegal front running. By the book they're obeying the law as it's a third party and either you get filled at or better than NBBO. Payment for order flow will disappear overnight if the law was updated that NBBO was calculated from every exchange. It's also not front running as they're not trading to profit off the stock movement created by your order, it's market making and market makers get a lot of rule exceptions. For example market makers can short stock without identifying shares before initiating a short sale. They get a lot of "unfair" advantages vs other traders. Your privacy is also not violated. Buffet himself could open a Robinhood account and probably could have a heyday taking advantage of payment for order flow. All the payer of order flow knows is it's trades "coming from Robinhood." Likewise, a hedge fund could open a Robinhood account if they so wanted. Robinhood can't legally disclose to them that a trade is coming from an account owned by Warren Buffet.

It's also not front running as typically the market maker will take retail flow unbalanced. You can picture a market maker like how a bookie operates in sport betting. Say you're betting on the Cowboys vs the Rams. Say a lot more bets are coming in for the Cowboys and in order to have a balanced book of matching a $1 bet for the Cowboys to a $1 bet of the Rams the market maker needs to up the odds where the Cowboys are expected to win 2x over the Rams. So $1 bet for the Cowboys will be a $0.50 payout if they win. If the bookie knows money is coming in from dumb people he probably won't update odds. If he knows money are coming in from sharps he better quickly get some business on the other side and probably adjust the odds quickly.

Going back to stock trading you can think of buyers and sellers as betting on one of two teams or an outcome - going up or going down. If there is a lot of sell orders suddenly the market maker will adjust prices down quickly. If the market maker knows these are dumb orders that have no information advantage then the market maker can wait a lot longer to balance his order book ("sportbook"). If the market maker decides to trade retail flow it's NOT front running, as the order is executed! Even if a market maker doesn't accept a order immediately (note - if the order comes in at their posted prices they MUST accept it always), the only way you'd get them on a front running scheme is if they knew it was Mr. Buffet's Robinhood account personally.

To balance the point of view here are some of the things proponents of payment for order fill claim that help retail investors -
1. They can do order combining. Say AMD becomes a "meme" stock and tons of retail investors are trading small number of shares then a order flow agreement can quickly say combine a giant order of 10,000 shares from say 400 people (25 share trades each) that come in over the course of five minutes and say submit them much more favorably, perhaps to a dark pool order as a [Block Trade](https://www.investopedia.com/terms/b/blocktrade.asp). Let's say AMD is currently has a NBBO of $40, and a VWAP of $38 (volume weighted average price.) Maybe some institutional investor wants to offload AMD at better than VWAP, but A if they did that on the open market it will tank AMD to down under $38, and B, they rather not trade against Goldman Sachs who may have insider information on AMD or better insight. So this is a win-win-win for everyone. Maybe the 400 people get filled at $39.50/share which is obviously way better than NBBO so no one can't complain, maybe the institutional investor gets filled at $38.50, which is much better than the VWAP price of $38, and the market maker made a easy $10,000 off the $1 spread through order combining. Everyone walks away happy in this example. Retail got a price they would otherwise were not legally guaranteed, institutional got a better price then their broker VWAP order, and the market maker got a pretty good spread for say maybe 5 minutes of an unbalanced book.
2. Liquidity - Someone on Robinhood that somehow shot up their account to $200k off $1k using stock options and is now YOLOing it on 5,000 shares of AMD. Let's say he's not completely retarded though and is smart to use a limit order instead of a market order. Let's say the tape is really quiet with lots of orders in 1-4 lots (100-400 shares.) If this 5,000 share order got sent to the NASDAQ it's going to scare away a lot of people. NASDAQ market makers are going to pin this dude's order. HFT is going to jump in and try to snipe the smaller 1-4 lots. This guy's order is going to take minutes to fill, and the market may move unfavorably for him in the mean time. He may have to resubmit. A payment for order flow provider here would probably be happy to take $200k unbalanced knowing it's from Robinhood and work the trade a bit smarter than the Robinhood guy did, earning a good spread. Only marketable limit orders, also known as an inside limit order, something that is more favorable than NBBO has to be routed to the exchange with the best NBBO price. However it's not required to be re-routed, and any unfilled portion of the limit order is the trader's responsibility. A payment for order flow provider knowing that 5k lot sitting on the NASDAQ is retail isn't front running as retail's order is placed first and made it onto the exchange. Then, if a limit order is NOT marketable then there is no NBBO protections and the broker may route it however they please as long as they route it.
3. Not moving the market - Going back to the $200k retail order example if a payment for order flow provider knows it's retail then the market is more likely to remain calm. It won't move against the trader.

Payment for Order Flow profits will be greatly reduced if non marketable limit orders still had to be routed to the NBBO exchange.

Anyways, I hope that gives some insight into the purported benefits of payment for order flow. It's really hard to say if it's a net benefit if it's harming the market as a whole. I've outlined some of the win/win trades vs some of the shit they get away with.

Oh, and to answer your second question most HFT traders ARE the market makers these days. You need to be HFT to profit off both market making and payment for order flow. I suppose you could profit off some quant stats say knowing robinhood favors AMD/etc, but when talking order flow you are 100% definitely in the realm of high frequency trading and market making.

Market making is a tricky business and it depends on the exchange. On NASDAQ each market maker is competitive and each stock has more than one market maker, on average there are 14 market maker firms per stock. They're required to be registered as a market maker at NASDAQ. They're required to post bid and ask quotes at all times at a minimum of 100 shares. They have pretty loose rules otherwise. They can short naked. Then on the NYSE there is at least one specialist for each stock. They operate an "auction market" where they post bids on behalf of buyers and sellers. They have an obligation to ensure a fair and orderly market and must put in their own capital if needed to fill orders. They're prohibited from trading ahead of investors. Essentially NASDAQ = wild west and NYSE = more orderly.

Finally new markets like IEX (https://iextrading.com/, https://iextrading.com/market-quality/) don't even post a order tape or anything, they attempt to get deep "midpoint" liquidity. They're one of the "dark pools" I've mentioned - (https://www.investopedia.com/terms/d/dark-pool.asp) they don't post a order book/L2 quotes at all like NASDAQ/NYSE does. These are for big boy institutional "block trade" orders that increasingly for good reasons don't participate on NYSE/NASDAQ anymore. So one argument is through order combining payment for order flow allows retail to participate in the benefits of exchanges like IEX/etc. For better or worse they're matching retail against institutions.

illumination
Posts: 672
Joined: Tue Apr 02, 2019 6:13 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by illumination » Wed Dec 18, 2019 11:35 am

The $4.95 that most brokerages were charging for a trade (or whatever amount it was) just a few weeks ago was likely a far bigger hit to the average retail investor than the higher price as a result of selling order flow. What I've read is wholesalers are pocketing fractions of a cent on trades.

I wouldn't let this practice deter someone from buying ETFs over Mutual Funds.

senex
Posts: 476
Joined: Wed Dec 13, 2017 4:38 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by senex » Wed Dec 18, 2019 12:44 pm

Dovahkiin wrote:
Wed Nov 20, 2019 4:03 am
National Best Bid and Offer regulations only requires that to be computed from a select few stock exchanges - specifically NYSE, NY-ARCA, NY-MKT, and NASDAQ. Over the years several "dark pools" and other stock exchanges have popped up - BATS, IEX, etc.
This post contains a lot of confusion and misinformation (but also some fun commentary on retail).

There are approximately a dozen protected exchanges that constitute the NBBO, including BATS. BATS is not a dark pool.

The NBBO is not one number, like "$20 a share at NBBO." As its name says, it is a bid and an offer, like 19.95 x 20.00. That's why the IEX example doesn't make any sense as written.

It's true that resting odd lots may be excluded from the the NBBO calculation, but Reg NMS requires all trades during market hours (regardless of where executed, or size of order) to be within the NBBO. The exceptions (like pre-arranged vwap trades) rarely apply to situations available to retail customers.

The latency advantage comment doesn't make sense as written.

I agree with the sentiment that most retail trading is uninformed relative to professionals. Some retail orders are indeed "insane plays" based on message board hype, people with gambling problems, etc.

---

Regarding the original question, say the NBBO for AAPL is stable throughout this example at 290.60 x 290.61.
You send a market BUY order. Your broker must decide where to send it.
Reg NMS forbids any fills above 290.61.

Your broker may send it to any of the exchanges offering 290.61, or may send it to a non-exchange venues (dark pools, "internalizers," etc) to see if they will fill at 290.61 or better. It is the broker's choice, subject to some "best execution" rules that get complicated.

If Citadel has "bought order flow" from Schwab, it means that Schwab sends some fraction of retail orders to Citadel before sending elsewhere. Citadel must immediately decide to fill at 290.61 or better or pass. If they fill at 290.61, you got the same price you would have gotten had you been routed to an exchange (assuming the exchange had no hidden orders; they sometimes do). If Citadel fills you at 290.609, you got price improvement ("a bettter price") over the NBBO (you paid less than if you had traded on visible exchange).

If Citadel passes, Schwab could try sending your order to another dark venue. After a certain number of tries (or amount of time), if still unfilled, Schwab would send your order to one of the visible exchanges quoting 290.61.

Some complexity arises if the NBBO changes while your order is in flight (either to your broker, or from your broker to another party). At the moment anyone (exchange, broker, dark pool, internalizer) decides to fill, they MUST fill within the NBBO at the exact moment the fill/nofill decision is made (if during market hours). The size of your order doesn't matter. The SEC audits this.

There is also complexity for wide-spread stocks. Say the spread is 19.90 x 20.00, and there is a bunch of hidden liquidity at 19.95. It is hidden, so not everyone knows about it. You may get lucky and get routed somewhere with 19.95 liquidity, and buy at 19.95. This happens. Lucky you! You were willing to pay 20.00, and you got it for 19.95. Or maybe, unluckily, the first dark venue fills you at 19.99. You're still kind-of lucky -- you paid 0.01 less than you expected -- but you're not as lucky as if you had hit the 19.95. And, the company that filled you at 19.99 may have some idea of liquidity at 19.95, and thus may be able to flip for a quick 0.04 profit. This sort of thing is endemic to any system that allows hidden liquidity and more than one exchange. It isn't a conspiracy or trick, even though it can sometimes allow advantages to more informed traders. The US "fair access" rules are very good, but data costs money, and the more one trades, the more "unpublished" info one can glean from one's own fills. The wide-spread situation is mostly restricted to small market caps. Most of the S&P 500 stocks trade (I think) at 1 penny spreads. When trading wide-spread stocks, you're free to place limit orders inside the spread to try to find the hidden liquidity.

It's possible for suboptimal outcomes (for you) if the market is moving rapidly. Citadel may say "no fill" because the market is moving, and by the time your order is routed elsewhere, the price has changed and you get a worse price. Verses if you had been routed to the exchange first, you may have gotten filled before the move. That is a bit of an agency problem, but in the grand scheme of life, the US markets are staggeringly fair, transparent, and efficient. A few decades ago you might pay a $100 commission and a $0.25 spread to buy IBM. Now you can pay $0 and less than $0.01. Amazing.
Last edited by senex on Wed Dec 18, 2019 3:31 pm, edited 1 time in total.

senex
Posts: 476
Joined: Wed Dec 13, 2017 4:38 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by senex » Wed Dec 18, 2019 1:43 pm

I like some of the examples and enthusiasm, but again, there are numerous errors:
Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Payment for order flow will disappear overnight if the law was updated that NBBO was calculated from every exchange.
NBBO is already calculated from all Exchanges (but not from all trading venues; a trading venue is not an exchange).

Unlikely that payment would disappear. The ability to trade with uninformed orders at aggressive prices has economic value, even if every trading venue was offering the same bid/offer.

Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Then, if a limit order is NOT marketable then there is no NBBO protections and the broker may route it however they please as long as they route it.
Not exactly sure what you're saying here. All trades must occur inside the NBBO per Reg NMS. If you place a non-IOC order inside the spread and it isn't filled by your broker/internalizers, your broker must post it on an exchange, where it becomes a protected contribution to the NBBO.

Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Payment for Order Flow profits will be greatly reduced if non marketable limit orders still had to be routed to the NBBO exchange.
You might mean, "if [they] had to be routed to an NBBO exchange *first*." They already are required to be routed if non-IOC and unfilled after trying non-exchanges. But under that definition, order flow is required to go to exchange -- which makes your statement a tautology: "payment for order flow is unprofitable if you can't direct order flow". Of course.

Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Market making is a tricky business and it depends on the exchange. On NASDAQ each market maker is competitive and each stock has more than one market maker, on average there are 14 market maker firms per stock. They're required to be registered as a market maker at NASDAQ.
Being a registered market maker has some obligations and some benefits.
You can function as a market maker without being a registered MM.

Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Essentially NASDAQ = wild west and NYSE = more orderly.
Most regulatory oversight is identical. NYSE has a few quirky leftovers from the days before computers, that in my opinion make it less orderly. Please explain specifically what you mean.

Dovahkiin wrote:
Wed Dec 18, 2019 3:51 am
Finally new markets like IEX (https://iextrading.com/, https://iextrading.com/market-quality/) don't even post a order tape or anything, they attempt to get deep "midpoint" liquidity. They're one of the "dark pools" I've mentioned
Incorrect. IEX is an Exchange that publishes their order book.
Also, "order tape" is not an industry term. You may be confusing the order book (the information about resting orders) with the tape (trades reported). Every trade must be printed on the national tape, even for dark pools (but again, IEX is not a dark pool).
Last edited by senex on Wed Dec 18, 2019 3:07 pm, edited 3 times in total.

Northern Flicker
Posts: 5842
Joined: Fri Apr 10, 2015 12:29 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Northern Flicker » Wed Dec 18, 2019 1:49 pm

Order flow payments are a kickback from the wholesale broker/market maker who executes a trade to the retail broker who sends a basket of retail trades their way. The concern the SEC has would seem to be that it can create a conflict of interest with the retail broker— do they choose the execution with the largest kickback or the execution with the best price for the buyer?
Risk is not a guarantor of return.

senex
Posts: 476
Joined: Wed Dec 13, 2017 4:38 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by senex » Wed Dec 18, 2019 2:17 pm

Northern Flicker wrote:
Wed Dec 18, 2019 1:49 pm
Order flow payments are a kickback from the wholesale broker/market maker who executes a trade to the retail broker who sends a basket of retail trades their way. The concern the SEC has would seem to be that it can create a conflict of interest with the retail broker— do they choose the execution with the largest kickback or the execution with the best price for the buyer?
Correct.

Reg NMS requires the trade (during market hours) to occur within the NBBO, which eliminates the most egregious opportunities for conflict. The retail customer, by placing a marketable order, is declaring that he is willing to pay the entire visible spread. So the problem reduces to a pretty tiny problem (in the grand scheme) of how much price improvement to freely give the customer, given some unknown decentralized set of hidden liquidity believed to exist in the world.

The current solution uses price improvement reports, after the fact, as one component of a "best execution" obligation of the broker. It's not perfect, but it's pretty good.

senex
Posts: 476
Joined: Wed Dec 13, 2017 4:38 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by senex » Fri Dec 20, 2019 2:20 pm

Explorer wrote:
Tue Nov 19, 2019 8:47 pm
I am trying to understand what this means and to whom the brokerages sell order flow.
OP, it happens that Matt Levine (probably the best/funniest financial commenter today) wrote about payment for order flow today:

https://www.bloomberg.com/opinion/artic ... tock-price

(go to the "Robinhood" heading partway down the page)

Northern Flicker
Posts: 5842
Joined: Fri Apr 10, 2015 12:29 am

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Northern Flicker » Sat Dec 21, 2019 4:41 pm

Here is a better description of what happened with Robinhood:

https://www.cnn.com/2019/12/19/investin ... index.html

which interestingly was published a day before Matt Levine’s opinion piece quoted above.
Risk is not a guarantor of return.

Topic Author
Explorer
Posts: 393
Joined: Thu Oct 13, 2016 7:54 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by Explorer » Sat Dec 21, 2019 9:11 pm

senex wrote:
Fri Dec 20, 2019 2:20 pm
Explorer wrote:
Tue Nov 19, 2019 8:47 pm
I am trying to understand what this means and to whom the brokerages sell order flow.
OP, it happens that Matt Levine (probably the best/funniest financial commenter today) wrote about payment for order flow today:

https://www.bloomberg.com/opinion/artic ... tock-price

(go to the "Robinhood" heading partway down the page)
senex - Thank you, the article was very easy to understand. Appreciate it.

HEDGEFUNDIE
Posts: 4801
Joined: Sun Oct 22, 2017 2:06 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by HEDGEFUNDIE » Sat Dec 21, 2019 9:56 pm

senex wrote:
Fri Dec 20, 2019 2:20 pm
Explorer wrote:
Tue Nov 19, 2019 8:47 pm
I am trying to understand what this means and to whom the brokerages sell order flow.
OP, it happens that Matt Levine (probably the best/funniest financial commenter today) wrote about payment for order flow today:

https://www.bloomberg.com/opinion/artic ... tock-price

(go to the "Robinhood" heading partway down the page)
+1

saver007
Posts: 166
Joined: Fri Nov 07, 2014 9:18 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by saver007 » Sun Dec 22, 2019 2:36 am

My understanding is that US has 80+ alternate trading systems (ATS). Liquidity in most of these ATS's are not displayed to market and thus not considered in calculating NBBO. Further, there is an inherent lag in calculating NBBO.

Honest brokers should invest resources to tap liquidity in the widest number of ATS as possible (expand their Network). Instead they wash their hands of their responsibilities by selling order flow and hide behind the lame legal standard of best execution.

senex
Posts: 476
Joined: Wed Dec 13, 2017 4:38 pm

Re: What "Exactly" Does Selling Order Flow Mean?

Post by senex » Thu Jan 02, 2020 4:15 pm

saver007 wrote:
Sun Dec 22, 2019 2:36 am
Honest brokers should invest resources to tap liquidity in the widest number of ATS as possible (expand their Network). Instead they wash their hands of their responsibilities by selling order flow and hide behind the lame legal standard of best execution.
The standard is nebulous but not lame. It is in fact quite active: brokers are required to oversee best execution and are fined when they do a poor job of it.

Each ATS connection costs money, costs time (when routing there), and potentially leaks information. You seem quite certain that a broker can handle these connections in-house cheaper than outsourcing and cheaper than the best-case price improvement that would accrue to customers. Neither of those points are clear to me. Ports and software developers are expensive, and all brokerage costs are borne by customers.

The general agency problem is unsolved, but the US Equity markets, offering instant execution from a massive decentralized pool of liquidity, some hidden and some visible, often for less than a penny a share, even when the customer is advertising his price-insensitivity, is quite an impressive system.

Post Reply