Instead of routing that order to a public exchange, the broker takes that order and sends it to the market maker. The market maker's able to fill the order at $100.01. The broker takes the stock, puts it in the customer's account, and proudly displays that it was actually able to get a better price than he asked for, which was also better than the exchange.
The market maker was able to offer the price at just $100.01 because it was also buying shares at $99.99. That price is also better than the NBBO. It can do that because the market maker is confident it can buy shares for less with other orders coming in, the exchanges, or institutional investors.
It's making $0.02 on every share. And even if it's paying the broker half a cent per share in exchange for routing its orders, it's still making a great profit.
Meanwhile, brokers are benefitting because they're getting paid to execute orders for customers instead of paying an exchange to do so. And customers can be happy that they get a better price than they were hoping to get.
Criticisms of payment for order flow
A broker has a fiduciary duty to get the best price possible for customers. If the market maker is skimming pennies off of every share and remitting a percentage back to the broker, can the broker truly claim it's getting the best price?
That may be true if the market maker is the only way to get that price. After all, a market maker is providing a service by always being ready to buy or sell at prices better than the NBBO. It should be compensated for the service (and the minimal risk it's taking).
But the market maker may be engaging in a different practice. It may be taking customer orders and fulfilling them at a certain price better than the NBBO, but immediately going out and executing an offsetting trade by accessing pools of liquidity that are otherwise publicly available. In that instance, the broker could theoretically get customers the best price by going around the market maker and routing trades to multiple exchanges and trading systems to find the truly best price for an order. In that instance, the customer is harmed because they're not actually getting the best available price.
Related investing topics
