Market Maker Corner: Payment for Order

pAyment for order flow

At Glendale Securities, Inc., we mainly make markets in OTC securities for our customers. We charge our customers a commission for execution and use our market making capabilities to facilitate customer executions.

We are often asked why we don’t offer commission free trading like some of the online retail brokerage firms offer. Wait, how can a broker dealer offer commission free trading? The answer to that question requires a discussion on the practice of payment of order flow, and a clarification on when payment for order flow is paid to brokers. Many large retail brokerage firms including the online ones you are probably familiar with do not make markets in stocks. To fill your order, brokerage firms have a couple of options, each with their own cost/profit structure. They can send your order to an exchange or ATS, but those often charge the broker on a net basis for execution. They can execute the order internally as a market maker, but that requires staff, technology, and risk capital that may be too cost prohibitive. Another option is to send customer orders to a wholesale market maker who pays the brokerage firm for its order flow. If you must choose between the three options outlined above, receiving payment for order flow for sending orders to a wholesale market maker seems like it’s the smartest option for the brokerage firm. The brokerage firm eliminates costs, doesn’t

Not all market makers pay for order flow, and many provide best execution regardless of their payment for order flow arrangements. At Glendale Securities, Inc., we focus on executing our customer’s orders to obtain best execution, regardless of how the order is executed.

need to add technology, increase its staff, or have excess risk capital available to execute orders. The brokerage firm then can pass those savings on to customers in the form of zero commissions. Sounds like everyone wins, doesn’t it? But wait, how does the wholesale market maker pay for order flow, when it must have the technology, staff, and risk capital necessary to execute the orders it receives?

Wholesale market makers must be able to profitably trade against client orders (on average) for the practice of payment for order flow to make sense for the wholesale market maker. This profit must be significant enough to continue to make payments to brokers that send them order flow. How does the wholesale market maker continue to make enough profit off these orders? Are wholesale market makers just smarter than everyone else, so smart that they always are profitable on average? It’s possible that the profits may come at the expense of clients in the form of inferior execution. That can’t be legal, can it? One famous brokerage firm was charged $65 million by the SEC because it “provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.” So its possible that wholesale market makers are smarter, they just are giving enough inferior execution to keep their average trading profits high enough to be able to afford and profit from payment for order flow arrangements. Another way wholesale market makers tip the table in their favor is by selecting the types of orders that they will make payments for order flow to brokers that send them orders. Wholesale market makers will typically not pay for orders in OTC stocks, including for OTC foreign securities that are quoted in the US with an “F” as the fifth letter in their ticker that denotes that they are foreign incorporated companies. Online brokers that do take orders in OTC stocks will often charge commission for OTC stocks. Other zero commission brokers will not even take an order in an OTC stock, possibly because they are not receiving payment for order flow.

Wholesale market makers compete for business by paying out larger amounts to brokers that send them orders. So, your broker may be choosing to send your order to the wholesale market maker that pays the broker the highest payment for order flow versus to the wholesale market maker that offers the best execution.

Not all market makers pay for order flow, and many provide best execution regardless of their payment for order flow arrangements. At Glendale Securities, Inc., we focus on executing our customer’s orders to obtain best execution, regardless of how the order is executed.

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