Most people with an understanding of the stock market know that when someone purchases shares, there needs to be a willing seller. The two parties use a broker to meet digitally at a
stock exchange (like the New York Stock Exchange or the Nasdaq Stock Market), where their transaction is facilitated.
But times have changed. The chairman of America's market regulator, the Securities and Exchange Commission (SEC), recently noted that only 53% of all customer orders actually go through an exchange. About 38% are handled by wholesalers instead, more formally known as market makers.
That's where payment for order flow takes center stage.
Market makers stand ready to buy and sell shares each trading day. They make money by setting the bid-ask spread. Let's say a market maker is willing to buy a share of
Apple for $145.50, and it's willing to sell a share for $145.60. The difference of $0.10 (the spread) is its profit.
When a Robinhood customer places a market order to buy or sell shares of Apple, rather being matched with a seller in the market, they are instead routed to a market maker, because it can be relied on to absorb the transaction in the blink of an eye.
Market makers can compete with each other for this order flow by lowering spreads -- for example, one might charge a spread of $0.07 instead of $0.10, so the broker would route the order to that firm to get its customer a better price.
Alternatively, and controversially, market makers can simply pay Robinhood to route its customers' orders to them, partly removing the need to compete. It has drummed up concerns among regulators that retail investors are getting a raw deal when it comes to the pricing and execution of their orders.
In December 2020, Robinhood paid a $65 million settlement to the SEC after the regulator discovered the practice had deprived customers of $34.1 million, caused by inferior order pricing -- and that's
after accounting for customers paying zero commissions.
