What Does Payment for Order Flow Buy?

I think there are two different intuitive models of payment for order flow. Let’s call them the Good Model and the Bad Model.

The Good Model goes like this. Lots of retail investors go to their brokerage looking to buy XYZ stock, and lots of retail investors go to their brokerage looking to sell XYZ stock. XYZ is available on the stock exchange; you can buy it for $10.02 or sell it for $9.98. Those prices on the stock exchange are called the “national best bid and offer,” or NBBO, and are set essentially by market makers, high-frequency electronic traders who are in the business of buying from sellers and selling to buyers. The spread — the $0.04 difference between the buying price (the offer) and the selling price (the bid)1 — is due to the fact that the market makers take lots of risk: If they buy stock on the stock exchange, probably some smart hedge fund is selling, and it will probably go down. So they need to buy at a fairly low price ($9.98) and sell at a fairly high price ($10.02) to compensate for this risk of “adverse selection,” this risk that whoever they trade with knows something that they don’t.