Signals: The stock market's Secret Menu

Hey Fintech Friends,

Let’s say you want to buy 5 shares of Hooli ($HOOL). Your broker, Robinhood, will execute the trade without charging you a commission. Instead, a market maker will pay Robinhood for the privilege of filling the order, otherwise known as payment for order flow.

Payment for order flow is already banned in the UK and the SEC is reviewing its role in US markets, but fans argue that without PFOF, retail investors would have to pay fees to brokers to execute their orders. And if retail investors pay less to trade, doesn't this make them better off?

The short answer: It's nuanced!

Let's dive into payment for order flow.

As your broker, Robinhood has to fill your order at the best price available in the market as quoted by the National Best Bid and Offer– in Europe, the European Best Bid and Offer. The NBBO/EBBO reflects a security's highest bid (selling) price and lowest ask (buying) price offered across exchanges at any point in the day. Robinhood can also offer you ✨price improvement✨ by filling your buy order at a price below the NBBO.

Let's say that the National Best Offer for a share of Hooli is $100. Robinhood has a few options for how to fill your order.

For starters, if Robinhood happens to have 5 shares of Hooli in its own inventory, it could simply internalize the trade by selling you these shares.

A second option would be to take your order to a public exchange like the NYSE. A public exchange would add the buy order to its order book and route it to the first matching sell order that becomes available. Public exchanges handle about half the trading volume in the US and offer transparency on how much securities are trading for, creating price efficiency for market participants. They also come with drawbacks.

In either scenario, your broker will charge a fee on the order of $3 to $7 for identifying a seller and executing the trade. This is IF Robinhood can find a counterparty willing to sell 5 shares, since public exchanges can't inherently guarantee liquidity. An order that's aggressively priced or involves a security trading at low volumes may not execute if nobody steps up to take the other side. In these instances, public exchanges will incentivize movement by appointing market makers who must step in to take the other side of the trade at pre-advertised prices and offer rebates to counterparties offering liquidity.

What Robinhood actually does when it receives an order is bring it directly to market makers. Wholesale market makers like Citadel will bid to execute the trade, Robinhood will select the market maker offering best execution (i.e. the most price improvement), and that market maker will pay Robinhood for the order flow.

If Citadel wins the bid by offering $99.50 per share ($.50 below the NBBO), you will realize price improvement of $2.50 across the 5 shares. In fact, retail brokers typically advertise substantial price improvement through the PFOF model as compared to the public exchange model.

Robinhood will be paid, say, 6 cents by Citadel. This is a smaller per-trade payoff than a $3-$7 commission, but Robinhood makes up for this by processing high volumes of trades. Citadel makes money on the spread between what they paid for the shares (say Citadel goes out and purchases $HOOL at $99 per share) and what you paid ($99.50 per share), resulting in a $2.50 payoff for Citadel.

Everybody wins, right?

Isn't it weird that Citadel was able to buy $HOOL at $99 per share when the NBBO indicated that $HOOL's going price in the market was $100? Where did they find shares selling below market rate?

As you'll recall, public exchanges account for half of US trading volumes. The rest takes place through internalized trades or in private exchanges known as alternative trading systems (or multilateral trading facilities in Europe). ATSs– and most notoriously, dark pools– match trades away from the eyes of the public, letting institutional investors place block trades without making a splash in public markets or revealing their strategies to competitors.

These pools give market makers access to offers that retail investors can’t see. They’re kind of like the McDonald’s Secret Menu, but for the stock market.

Market makers have a more sinister reason to love private exchanges: Information asymmetry.

Retail investors trade on public information about how stocks are moving. When more information is available, the spread between the National Best Bid and National Best Offer tightens. Retail investors benefit from seeing increased gains from selling and lowered costs to purchase securities. Market makers, on the other hand, lose profit on lower bid-ask spreads, so it behooves them to keep their orders away from public markets.

To top this off, the payments that brokers like Robinhood receive from market makers are calculated as a percentage of the NBBO, so brokers also have an incentive to keep these spreads high.

BestEx Research estimates that if retail order flow were fully routed to public exchanges, NBBO spreads would narrow by 25%. This seemingly makes little difference to a retail investor executing smaller trades, but NBBO spreads are in danger of rapidly increasing as trading volumes continue to shift away from public markets:

On the face of it, retail investors benefit from PFOF by avoiding broker commissions and often getting a better price than the market rate. In practice, we have no idea how true this is. There are private pools full of orders that retail investors are completely unaware of.

What we do know is that if all trading flow was routed to public exchanges, we'd see higher competition to fill orders, which would result in better execution for investors. And if brokers had to reinstate commissions to replace PFOF, competitive pressure among brokers would similarly minimize these fees.

The bigger, overarching problem is that order volumes are increasingly being funneled to private exchanges, away from the public eye. If market makers love the information asymmetry that gives them an edge in executing orders, retail investors should be wary of brokers routing their trades to these firms. Regulators should work to curtail the practice before too much order flow ends up in dark pools (or elsewhere behind the PFOF curtains).