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I understand that retail brokers pass their customers' trades on to trading firms, and receive a payment for order flow in return. These trading firms carry out the trades and presumably also have to pay per-trade exchange fees to the stock exchanges. So if they pay to both sides, how can they make money?

A recent article in the New York Times (Robinhood Has Lured Young Traders, Sometimes With Devastating Results, 8 July 2020) described the setup thusly: "Each time a Robinhood customer trades, Wall Street firms actually buy or sell the shares and determine what price the customer gets. These firms pay Robinhood for the right to do this, because they then engage in a form of arbitrage by trying to buy or sell the stock for a profit over what they give the Robinhood customer." I have a hard time understanding this paragraph. Does it mean that the customer receives a worse price than is available at the stock exchange at the time, and the trading firm pockets the difference?

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  • $\begingroup$ By law they have to give you a price not worse than on the exchange at the time. However an HFT firm may have access to institutional investors who are trying to sell the stock without going through the exchange (for many good reasons, you can assume that they know what they are doing). The hft may be able to buy from an institutional investor at a price equal or slightly below exchange price and immediately resell it to you at exchange price, pocketing a small profit when the "payment for order flow" is taken into account. It is more complicated than just 'arbitrage'. $\endgroup$ – noob2 Jul 12 at 18:53
  • $\begingroup$ There is nothing illegal, it may seem a bit unfair that sophisticated investors are able to take advantage of the unsophisticated (but isn't it always so?). But the real issue IMO is that the central role of the exchange in price discovery has been reduced by allowing this kind of off exchange trading. This is the public policy issue that needs to be discussed, IMO. $\endgroup$ – noob2 Jul 12 at 19:16

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