The NYSE happens to have 50 sale orders of GME at $200.25 and 50 buy orders at $200. Traditionally, a broker would send their customers’ orders to the NYSE, executing the buy and sell orders at $200.25 and $200 respectively; paying the exchange a small fee for executing the orders.
Robinhood pioneered a new methodology, by partnering with a wholesaler, for example Two Sigma Securities LLC (TSS), they could match the buyers with the sellers. The buyers could pay $200.15, saving $0.10 and the sellers would receive $200.10, gaining an extra $0.10, with Robinhood and TSS sharing $0.05. Win, win, win.
In this example, payment for order flow results in better pricing for retail traders. We should note that whilst it is unlikely orders are submitted simultaneously, with offsetting buys and sales at fixed prices, our simplifying assumptions remain reasonable. Wholesalers generally receive offsetting orders within milliseconds, seconds or minutes. A fixed price is a fair assumption given retail traders are less informed, small and dispersed, their trades appear random, providing little to no insight to wholesalers; if TSS buys a stock from a retail trader, TSS has no reason to think the stock will go up or down. Counter to the popular concern of front-running, which remains illegal, this suggests there would be little to no value in front-running retail traders.
It’s worth noting that wholesalers aren’t obligated to fill every order, and pass some orders to an exchange. They don’t provide a price improvement on 100% of orders; however, they are pitted against each other and evaluated on the price improvement they offer, ensuring a competitive market.
