[blueblisters]

Zerodha (top Indian broker) posted an article earlier which explained why the Indian brokerage industry has very few avenues to make revenue: https://zerodha.com/z-connect/rainmatter/the-race-to-zero-ca...

The lack of any mechanism for payment for order flow is quite interesting - how do market makers get incentivized to provide liquidity in such situations? Or asked another way, are American market makers being subsidized by retail traders?

[seanhunter]

Market makers are incentivized to provide liquidity by the fact that they earn half the spread on average every time they trade. If a stock trades for 10 bid 11 offer then the market maker makes 1 every time they buy at 10 and sell at 11. They do this a very large number of times a day.

I'm not sure this still happens, but Marketmakers (and broker dealers) also used to earn rebates from new venues to incentivise them to trade on MTFs (multilateral trading facilities or alternative execution venues).

You'll hear a lot of people talking about market makers (eg Citadel) paying for flow. The common opinion is that this is because that flow contains information that the marketmaker can profit from. This is almost never the case, and in fact if the flow has alpha (positive or negative) or is overly directional that's not great for the marketmaker as they are forced to temporarily take the other side of that trade and try to find unwinds. Marketmakers want more flow because that makes it easier for them to do their job of hedging their inventory and unwinding positions with minimal impact. They are betting on the underlying math that if the flow gets large enough it becomes zero alpha by definition and they can just earn the spread.

[twic]

To expand on this a little for anyone interested, the problem with classical market-making is that you only make money as long as the trades are crossing back and forth around a stationary price. If the market moves suddenly, you end up losing money. In your example, if a huge sell comes in at 10, and the market then moves down to 8 bid, 9 offered, the market maker has a position they bought at 10, but can only sell at 9 at best.

So, profitability depends on the ratio of the nice "random crossing" to the nasty "toxic flow". The toxic flow tends to come from large, well-informed market participants who can act very quickly. That means institutional players with colocated trading machines and so on. There are none of those on retail brokerages, so retail flow has a great ratio of random crossing to toxic flow, and so market makers are happy to pay for it. Meanwhile, the exchange itself is crowded with players like that, and there's a worse ratio, so market makers are a lot more wary.

This is why market makers invest a lot in low-latency trading. If you can find out about an impending market move, and cancel your resting orders before other participants cross into you, you can dodge the toxic flow, and have a better chance of making money.

Longer explanation: https://insights.deribit.com/market-research/toxic-flow-its-...

Unrelatedly, another source of revenue for market makers is maker-taker pricing, where the person crossing the market pays a little fee to the person who rested the order they crossed into:

https://www.investopedia.com/articles/active-trading/042414/...

But i'm not sure how common this is these days.

[cardiffspaceman]

The market needs the retail investors but if bad things happen to retail investors often enough, they will retire from the fray. Enjoy your always-toxic trades.

[twic]

Retail traders might be scared off, unfortunately, but retail investors will keep coming.

[kgwgk]

> how do market makers get incentivized to provide liquidity in such situations?

Buy low, sell high.

PS: By the way, I'm not sure I understand the question. Market makers are the ones who pay for the order flow.

[smabie]

maker rebates also are a pretty significant incentive