Apologies if this is a very simple question, but how exactly do firms make money from "flow trading"? Is it simply profiting from "selling" direct market access?
Flow trading is in spirit very similar to market making - such firms make a profit by earning a spread.
There are 3 common ways this is done. Suppose a client wants to buy 100k shares of XYZ, which is publicly quoted at [email protected] bid, [email protected] ask. For sake of simplification, assume sub-penny pricing is not accepted in the jurisdiction where XYZ is listed.
Match against inventory: The firm already has a position of 100k shares of XYZ at an average fill price of 10.015. In theory, the firm has an unrealized loss at liquidation price on the public market. Now, the firm can sell all 100k shares to the client at 10.02, which is an improvement over the public best offer of 10.03 for the client, while the firm also collects a spread of 0.005x10^5=$500 - a win-win situation.
Instantaneous: The firm does not have a position in XYZ. Nevertheless, the firm can sell all 100k shares to the client at 10.03 immediately. Since this is the best offer price on the public market, the firm benefits because it has likely skipped the queue at 10.03 to get a fill. Now the firm can work the offsetting order, wait for a client that wants to sell XYZ, hedge its position, or improve the public best bid by posting buy [email protected] where it would earn a spread of 1 cent.
Combination of the above: The firm already has an inventory of 80k shares at an average fill price of 10.01. It can sell 100k to the client at 10.02 and simultaneously buy 20k from the market at 10.03, thus realizing an average entry price of 10.014 and average exit price of 10.02, collecting a spread of 0.006x10^6=$600.
(1), (2) and (3) suggest that all previous replies to your answer are misinformed, it is entirely possible to do this in a way that neither frontruns the client nor disadvantages the client relative to NBBO. On the contrary, the client may be a noise trader and frontrunning its order may actually work against you.
(1) suggests that the firm needs to already be in the business of holding on to a large portfolio which it wants to be at net zero exposure, this is why many flow trading firms are also large broker-dealers.
(2) suggests that the flow trader collects profits at the expense of the otherwise market makers who were quoting 10.01-10.03 and would've loved to compete for the business of filling those 100k shares. The moral issue arises here as one may argue that the flow trader is collecting its profit at the expense of its client: perhaps a high-frequency market maker on the exchange would've been willing to cross the spread and sell at 10.00 if it saw a [email protected] bid post because the public market maker has prediction alpha. By internalizing the flow, we're removing competitive price discovery from the public market. This lends credence to why most high-frequency trading firms prefer lit and transparent markets, which are more competitive for the utility traders, investors and end users of these markets.
As to the value that customer order flow provides, there is specific published research on order flow in the FX markets by Sarno et al. (Why) Does order flow forecast exchange rates?