I'm ignorant of this space. Can you share how Robinhood and others make money through order flow?
The semantics of it (an order has to receive the best price at the time of execution for example) doesn't capture the N ways a fund could make money here and still be compliant.
Instead of worrying about the incorrect definitions used, can you share how firms benefit from order flow instead?
The exact mechanisms by which MMs monetize order flow is the strictly guarded secret sauce. But largely it’s because retail order flow is uninformed, versus institutional order flow (bank, hedge fund, etc) which might be “toxic”.
Here’s an example with ridiculously huge spreads but just to help illustrate the issue (in reality, the spreads are fractions of a cent): let’s say the market for AAPL shares is 150 vs 151. A retail trader market sells 100 shares. Absent a dark pool or other internalizer, they will end up hitting the 150 bid. A market maker knows there is a buyer for AAPL shares and expects the 151 offer to trade. The market maker (MM) pays 10c to Robinhood for the order, and buys the shares at 10c better @ 150.10. The MM has paid 150.20 effectively (151.10 + 0.10) when the next best buyer in the market was 150.00. Why would they pay a 20c premium? Because of the buyer I mentioned earlier that the MM believes will buy their shares. The MM turns around and offers these 100 shares for 150.90 (which is 10c better than the best current offer of 151.00) and a hedge fund immediately snaps those shares up.
So what’s the net outcome? In this case, the trader has gotten a better price, Robinhood has received revenue and can offer their service for free, the MM has made a 70c turn on the trade (150.90 - 150.20) and the hedge fund buyer got a 10c better price than was available to them in the first place.
Win, win, win, win.
(The real issue is that Robinhood forces market orders which make retail traders consumer of liquidity and makes all of this possible. But that’s a different issue and PFOF is not the bad guy.)
> The market maker (MM) pays 10c to Robinhood for the order, and buys the shares at 10c better @ 150.10. The MM has paid 150.20 effectively (151.10 + 0.10) when the next best buyer in the market was 150.00.
Is this possible due to the technicalities in regulations? Since they're paying a better price, it's OK that they purchase the order from Robinhood and fill it themself? The order didn't hit the "open market" or whatever we'd consider it. It was filled before then, but the best price on the open market was less than what was filled for, regulators are happy.
Very interesting that the money is from retail customers selling at bid, and makes sense.
If you'd like to share -- what's front running in this scenario and how would MMs front run this, assuming it's legal.
> Is this possible due to the technicalities in regulations? Since they're paying a better price, it's OK that they purchase the order from Robinhood and fill it themself? The order didn't hit the "open market" or whatever we'd consider it. It was filled before then, but the best price on the open market was less than what was filled for, regulators are happy.
Sort of. It’s because the MM know that it’s retail order flow. Let’s say we forced all the volume to a lit exchange. The MM might not be willing to pay 10c (the fact that they don’t proves this) because when a fund comes in to sell, it won’t be just 100 shares. It will be 1mm shares, and so MM don’t want to quote sharp prices and then get run over with a huge order.
People think it’s MM ripping off retail. It’s not. It’s MM giving better prices to retail and ripping off professional traders.
https://www.sec.gov/news/press-release/2021-167 (SEC Requests Information and Comment on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology)
It’s really no different then incentives and financial mechanisms casinos use to get folks in the door. Or, as the saying goes, “if you don’t know who is the sucker at the poker table, it’s you.”
Whether or not Robinhood gamifies trading, or encourages gambling, has absolutely nothing to do with PFOF.
Ultimately people should be able to do with their money as they please, include gambling it away on risky options trades. Bad trading is naturally self correcting.
You asked me what the inherent conflict of interest is top of thread. I stated it. The goal posts are firmly where they started.
Robinhood is getting paid to bring a product (the user) to market makers. If you’re not paying for the product you’re the product, all the jazz.
> Ultimately people should be able to do with their money as they please, include gambling it away on risky options trades. Bad trading is naturally self correcting.
Agree to disagree. We regulate smoking, alcohol, pharmaceuticals, gambling, and other behaviors that have self harm. This is no different.
Yes, I said that within the context of this thread, which is PFOF…
If you’re arguing that there’s a conflict of interest between Robinhood and its customers, then sure. But that’s got nothing to do with PFOF.
> Agree to disagree. We regulate smoking, alcohol, pharmaceuticals, gambling, and other behaviors that have self harm. This is no different.
Sure, I never said no regulation. You gotta stop with the strawman attacks. We regulate these industries, as we ought to do with finance, but we nonetheless allow people to drink/smoke themselves to death or gamble themselves into oblivion.
I’d rather live in a society where a small number people do enormous bad to themselves, over one where the state makes decisions for everyone.
So by definition, the “worst price” would be routing via SIP and execution against NBBO.