Payment for Order Flow
A prototype for platform finance
History is now being written on January's GameStop dust-up. I guess it is not untrue that it was a "surge in trading by inexperienced amateurs," but that downplays its systemic aspects. From a systemic perspective, the point was not amateur traders on Reddit and Robinhood, managing to bruise hedge funds but hopelessly outmatched in the end. Instead, we should be looking at what put those amateur traders there in the first place. From this angle, the story is about payment for order flow.
Citadel Securities, a wholesale market-maker, pays a fee to Robinhood, an online broker, for the privilege of executing Robinhood's users' trades. Other brokers and other market-makers are engaged in the same trade, worth some $3bn in the US in 2020.
Elsewhere I noted that Robinhood's users mistakenly believe themselves to be its customers. In fact they are its product, in a new twist on the 1973 Richard Serra and Carlota Fay Schoolman film “Television delivers people.”
For Soon Parted, the question is: why is Citadel Securities willing to pay so much for Robinhood's order flow? How can Citadel pay to keep Robinhood's lights on, execute trades for its users, and still come away with a profit?
Citadel is acting as a dealer, willing to buy and sell out of its own inventory at prices it sets. For this I use the dealer model:
Going across is Citadel's inventory. Think of this as its inventory of a single stock, say GameStop. (It could also be interpreted a bit more loosely as Citadel's aggregate inventory, a metric of the vector of its holdings of all stocks.) Inventory can go negative because shares can be borrowed, so zero is at the center rather than to the left.
Citadel sets prices, an inside bid or buying price and an inside ask or selling price. The market-maker profits because its ask is above its bid: it buys low and sells high. Because Citadel trades when users want to, it has to allow its inventory to fluctuate.
Inventory must be financed. That expense is minimized if Citadel can keep inventory close to zero, halfway across in the diagram. Citadel can do this by lowering the price when it buys, and raising the price when it sells. This brings in new buyers when Citadel would like to sell; it brings in new sellers when Citadel would like to buy. So the inside bid and ask lines slope downward in the diagram.
At some point Citadel reaches the maximum inventory it is willing to carry. At that point it sells to some other buyer. Or it reaches the minimum inventory it is willing to carry, at which point it buys from some other seller. The prices at which these transactions occur are the outside spread. Other traders also have access to the outside spread, so for Citadel to keep its business, it must offer prices within that range—no worse than the rest of the market.
Citadel makes an average profit on each transaction. That profit is greater when the outside spread is wider and the number of transactions, order flow, is larger.
Citadel is willing to pay to increase that order flow. For the market-maker, there several consequences. More orders: Citadel is paying for Robinhood to not execute its users' trades elsewhere. But also the dealer economics change:
The outside spread can be thought of as the best prices offered by the rest of the market. Because Citadel is buying a larger share of all orders, that spread becomes wider than it would otherwise be. That gives Citadel space to widen its own spread, increasing its profit from each transaction without requiring more inventory.
Finally, increasing its share of all orders makes it more likely that Citadel will have a buy order in hand when it receives a sell order, and vice versa. So it can more frequently transact without any impact on its inventory at all.
All of this means that Robinhood's users are trading at wider spreads than they otherwise would. This cost is practically invisible to small traders, but it is the source of the $3bn that market-makers paid for order flow.
What is this about?
I would call Robinhood and similar brokers platform finance. Payment for order flow lets us see how this trend is developing.
On the surface, it looks like Citadel is a wholesaler, Robinhood is a retailer, and Robinhood's users are the consumers. But this is wrong, because Citadel pays Robinhood and users do not. It's more accurate to say that Citadel is the customer, Robinhood is the intermediary, and the users are the product.
The Robinhood–Citadel example, though it grabbed headlines and led to a legislative hearing earlier this year, seems confined to equity speculation and probably is not wired into more complex financial contracts. But the dealer economics sketched above are in no way specific to equities: as technology makes it possible to aggregate large flows, like retail equity trades but also like other cash-flow streams, similar logic could be used by makers of other markets. (Order flow swaps?)
Liquidity, the facilitation of trading, is not free to provide, and those who provide it do not give it away. If end-user commissions are zero, that just means that the price of liquidity is being paid somewhere else.
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