> This is how Robin Hood can offer free equity trading. They sell your flow to another firm that can front run it.
This is not true, and front-running trades is both easy to catch and illegal. This is a bad combo for any white-collar crime.
You are correct that they make money by selling non-toxic order flows, but non-toxic here just means that retail investors tend to be "dumb money."
Market-makers need to estimate how much an asset is worth to be able to quickly fulfill orders - they can't instantly find people to take the other side of their users' trades. For example, user A buys Gamestop at $10/share, the brokerage accepts the trade and internally writes an IOU for that share, but later on realizes that the true price of Gamestop is $10.05/share. This means that the brokerage will lose $0.05/share because the price they estimated for the asset was too low. If too many orders from a source are like this, the source is considered toxic because the market-maker will generally lose money on them.
Some types of traders have highly toxic order flows. For example, HFT firms exploit <1ms latency in market makers' price estimates to systematically make money off the differences. Large funds can also place massive orders in a way that moves the entire market to make these estimates wrong.
Retail traders, in contrast, don't reliably know when a stock is mispriced. If Jimmy Bob Joe blows his college fund buying TSLA for $250/share, the exchange can probably give him TSLA at that price and not lose money.
If a market-maker gets too many toxic orders, it has to offer their clients worse prices to compensate for mispricing risk. Worse prices drive customers away, so they will often choose to pay for nontoxic orders to keep that risk down. We, the retail investors, get to trade for free at better prices and the market-makers get to turn a profit.
> it is literally a fox in the chicken coop.
The foxes here are HFT firms, and the chicken coop is any market where you end up trading with them. These "dark pools" benefit the little guys because they exclude the more predatory traders.
Or, to frame what you said in slightly different terms:
Why do people say "the HFTs" are the enemy? I mean, it's kind of true (the mental image I have of HFT firms and hedge funds is of a swarm of locusts descending on anywhere they smell money), but it's missing a super critical piece: there's more than one HFT locust swarm, and they all hate each other. They'd much rather screw each other (more money there!) than screw you (not as much money!) and they're willing to pay you if you can help them do it.
That's what payment for order flow really is: small bribes to send them something useful (non-toxic order flow) which they can then use against each other. Retail traders aren't the ones losing out here (or, if they are missing out, they're paying less than they'd pay under the old commission structure, so who cares).
This is not true, and front-running trades is both easy to catch and illegal. This is a bad combo for any white-collar crime.
You are correct that they make money by selling non-toxic order flows, but non-toxic here just means that retail investors tend to be "dumb money."
Market-makers need to estimate how much an asset is worth to be able to quickly fulfill orders - they can't instantly find people to take the other side of their users' trades. For example, user A buys Gamestop at $10/share, the brokerage accepts the trade and internally writes an IOU for that share, but later on realizes that the true price of Gamestop is $10.05/share. This means that the brokerage will lose $0.05/share because the price they estimated for the asset was too low. If too many orders from a source are like this, the source is considered toxic because the market-maker will generally lose money on them.
Some types of traders have highly toxic order flows. For example, HFT firms exploit <1ms latency in market makers' price estimates to systematically make money off the differences. Large funds can also place massive orders in a way that moves the entire market to make these estimates wrong.
Retail traders, in contrast, don't reliably know when a stock is mispriced. If Jimmy Bob Joe blows his college fund buying TSLA for $250/share, the exchange can probably give him TSLA at that price and not lose money.
If a market-maker gets too many toxic orders, it has to offer their clients worse prices to compensate for mispricing risk. Worse prices drive customers away, so they will often choose to pay for nontoxic orders to keep that risk down. We, the retail investors, get to trade for free at better prices and the market-makers get to turn a profit.
> it is literally a fox in the chicken coop.
The foxes here are HFT firms, and the chicken coop is any market where you end up trading with them. These "dark pools" benefit the little guys because they exclude the more predatory traders.