A wholesaler internalises retail marketable orders 0.1 cents inside the quote and pays the broker 0.15 cents per share. The exchange spread is 2 cents. Explain how the wholesaler profits at a price no exchange maker can match, and what happens to the exchange spread.

A wholesaler internalises retail marketable orders 0.1 cents inside the quote and pays the broker 0.15 cents per share. The exchange spread is 2 cents. Explain how the wholesaler profits at a price no exchange maker can match, and what happens to the exchange spread.

Approach: Compare the markout on retail flow with the markout on exchange flow, then ask what the residual flow reaching the exchange looks like once the retail part has been removed.

The wholesaler is buying flow whose markout is close to zero, so its cost of quoting is the 0.15 cents it pays rather than the adverse selection an exchange maker carries. On a 2 cent spread the midpoint is 1 cent inside the quote, so filling a retail buy 0.1 cents inside the offer captures 0.9 cents of that half spread; after 0.15 cents of payment for order flow the wholesaler keeps 0.75 cents against a markout near 0.1 cents. Internalisation works because retail orders are close to uncorrelated with the next price move, and that is the one property an exchange maker cannot select for. Removing that flow raises the informed share of what is left, so exchange makers see worse markouts and quote wider, and the price improvement retail receives is partly funded by the wider spread everyone else trades against.

Follow-up: If a broker routes 30% of its retail flow to the exchange instead, how does the wholesaler's bid for the remaining 70% change?

Key concepts: payment for order flow, internalisation, adverse selection, markout, price improvement.