Dark Secrets: Internalization and Payment for Order Flow

Many of these retail orders are internalized. In simple terms, that means the opposite party to your executed order was your broker/dealer themselves. These retail orders never leave the brokerage house. Other times your broker will ship your order to a market-maker. The market maker will pay your broker a fee, for the privilege of trading against your order. This is known in the industry as “payment for order flow”.

In general, market makers such as dealers, HFTs and securities exchanges are willing to pay a broker for the right to transact with that broker’s clients because they believe those clients will be uninformed traders—retail or other investors who are trading because of emotion or the need to raise cash and not because they know an asset is misvalued.

Why is there so much interest in trading against retail orders? Because many retail orders are “uninformed”, meaning they don’t have much knowledge of where the stock is going in the short-term. The most uninformed order is the “market” order, which is willing to pay any price to buy or sell the stock.

Market orders are very attractive to trade against because it allows the broker/dealer, or market maker the best chance of capturing the spread.

High frequency traders HFTs buy order flow. For HFTs, order flow is signed transaction volume: if a transaction of 100 shares is classified as a “buy”, the order flow is +100; if it is classified as a “sell”, the order flow is -100. The “buyer” is defined as the one who is the “aggressor”, i.e. one that is using a market order to buy. (And vice versa for the seller.) The intuitive reason why a series of large “buy” market orders are predictive of very short-term( speaking of  seconds or minutes here.) price increase.