Payment for Order Flow Explained

Wholesalers pay retail brokers for order flow because that flow is far less likely to be informed than institutional order flow.

Payment for order flow is an arrangement in which a retail brokerage routes its customers' marketable orders to a wholesale market maker, and the wholesaler pays the broker for that flow rather than routing it to a public exchange. The wholesaler profits from the bid-ask spread on flow that is statistically less likely to be informed than institutional order flow, and shares part of that profit back with the broker that sent it.

A small number of firms internalize the majority of United States retail equity order flow, with Citadel Securities among the largest. These firms act as the counterparty to a retail marketable order directly, filling it from their own inventory rather than sending it to an exchange to interact with the public book.

In exchange for the flow, the wholesaler typically provides price improvement relative to the national best bid and offer, meaning the retail customer trades at a slightly better price than the public quote, while the wholesaler still captures a spread that is wider than what it would earn trading against informed institutional flow at the same nominal price, a distinction covered in how the national quote is built.

Wholesalers compete for this flow directly with each other, since more than one wholesaler is typically willing to internalize a given broker's volume. This competition is part of why price improvement figures have generally trended in the retail investor's favor, as wholesalers bid against each other for exclusive or near-exclusive access to a broker's flow.

A retail market order to buy 100 shares of a large-cap stock carries very little information about where the price is going next. It is far less likely to be followed by an adverse price move than an order from a quantitative fund acting on a short-term signal. Wholesalers can quote tighter and still profit against this kind of flow because the information risk is lower.