← Money Lessons with Andrew Temte, PhD, CFA
Money Lessons with Andrew Temte, PhD, CFA
Payment for Order Flow: Who Pays for Your Free Stock Trade?
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In 2013, an app called Robinhood started building its whole business on charging nothing to trade stocks. So if millions of people are trading stocks for nothing, the money has to come from somewhere. And here's the uncomfortable truth. When the trade is free, the thing that's being sold is your order. Hi, I'm Andy Tempte and and welcome to Money Lessons. Join me every Saturday morning for bite sized lessons that are designed to improve financial literacy around the world. Today is July 11, 2026. Last week we met the Exchange Traded Fund, or the ETF. We also indicated that you can buy ETFs and individual stocks through commission free trading apps where placing a trade costs you nothing. Then I left you with a question that has sat unanswered since our November 29th episode back in 2025. If the trade is free, how does the app behind it make its money? The answer has a name and it's called Payment for Order Flow. And it tells you who is really on the other side of that free trade. Now, not so long ago, every stock trade came with a commission, often tens of dollars per trade. Somet even more over the years those fees have come down. And in 2013, an app called Robin Hood started building its whole business on charging nothing to trade stocks. Robin Hood was not the first company to offer a free trade, but it grew fast enough that the major brokerages had to follow suit. By 2019, most of them had cut their commissions on stock and ETF trades to zero. Trading stocks without a commission had become ordinary, though many brokers still to this day charge fees on other types of trades like options and futures. But running a brokerage isn't free. There are computers, employees, licenses, and a mountain of regulatory compliance to pay for. So if millions of people are trading stocks for nothing, the money has to come from somewhere. And here's the uncomfortable truth. When the trade is free, the thing that's being sold is your order. Now, when you tap the Buy button on a commission free trading app, the app hands your order to a wholesale trading firm called a market maker. We've met examples of market makers before. This is the firm that stands ready to buy and sell a stock all day long. What's new here is where your order goes. Instead of being transmitted to a public stock exchange and the designated market maker for that exchange, it travels straight to one of these third party market makers. The market maker fills your order itself out of its own supply of shares. And it earns its money on the small gap between the price it buys buys at and the Price it sells at. This is the bid ask spread that we met back on March 14th of this year. Sell to one customer at the asking price, buy from another at the slightly lower bid, and the firm keeps that little sliver of cash in between. On a single trade, that sliver is almost nothing. But across millions of trades a day, being a market maker can be very good business. Here's the piece that completes the picture. In exchange for the app sending your order its way, the market maker pays the app a small fee in return that payment a market maker paying your broker for the orders you place that has that name. Payment for order flow. Your broker makes its money not by charging you, but by selling your order to the firm that fills it. A handful of market makers handle the vast majority of this work. Three of them, led by a company called Citadel securities, together fill more than 80% of all retail orders that are routed through payment for order flow in the United States. Now, why would a firm pay to fill your trade at all? Well, a few weeks back we saw that market makers can see the flow of everyday orders that the rest of us can't. And they will also pay to get that order flow. The reason is that a small order from an individual investor like you or me is exactly the kind of order that a market maker wants. It's predictable and low risk to fill. You are almost never trading on proprietary information that is about to move the price against the market maker the moment it fills your order. Large orders from professional funds are a different matter altogether. They are bigger and they more often come from someone who has done deep research and expects the price to move. Fill an order like that and the market maker can be left holding shares that lose value moments later, exactly as the professional expected. And that is how a market maker can lose money. Your ordinary order carries none of that danger or risk, which is why it's worth paying a broker to get. Now for the catch. Your broker decides which market maker gets your order, and it has every reason to send it to whichever firm pays the broker the most, which is not necessarily the firm that gives you the best price. That is a real conflict of interest, sitting quietly underneath a button on a trading app that says free. Now, there is a contrarian view here. Market makers compete with one another to win a broker's order. And one way that they compete is by filling your order at a price that's slightly better than the best available price on the public market at that moment, a small edge of called price improvement. But the conflict of interest doesn't Go away. Which is why securities rules require every broker to seek the best price reasonably available for your order. And that duty has a name. It's called best execution. And it's not optional for brokers. In fact, in 2020, the U.S. securities and Exchange Commission, the SEC found that Robinhood had failed that d. It concluded that the company had misled its customers about how much of its money came from selling their orders and that those customers had received worse prices as a result. Roughly $34 million worse in total. Even after counting everything those customers had saved by trading without a commission, Robinhood paid a $65 million penalty to settle the charges. Free, it turned out, was not free. So what does this mean for you? Is your free trade really free? Not quite. You pay no commission, but a small slice of the value in your trade goes to the market maker that fills it. For a long term investor buying a few shares of a big, heavily traded company, that slice is tiny. The real cost of a free trade is not that tiny slice. It's the incentive. The whole arrangement creates. A business that earns money every time you trade has every reason to make trading feel easy, fast and exciting. The price that flickers in front of you all day, the little dopamine rush you get when you tap the buy button and the nudge to do it again and again and again. Last week I asked you to hold an exchange traded fund like the calm index index fund that it is on the inside. This is the other half of that lesson. The company behind that free trading app that you have earns its money when you trade, often, not when you buy and hold. It is worth knowing that reasonable people disagree about whether any of this should be allowed at all. And I'm talking specifically about payment for order flow at the end of June of this year. Just a couple of weeks ago, the European Union finished banning payment for order flow outright on the principle that the firm filling your trade should not be paying your broker to send it there. The United States looked at the same conflict and chose to keep the practice requiring brokers to disclose it instead. One arrangement, two regulators. Opposite answers. Next week, when we get back together, we're going to widen the map a little bit. We've spent this entire series inside American markets, American companies and American exchanges. But a large share of the world's great companies trades somewhere else entirely. So next week it's international equities and why the rest of the world deserves a place in how you think about owning stocks. Until next week, I wish you grace, dignity and compassion. My name is Andy Tempte, and this is Money Lessons. You can find the show on all the major streaming services as well as out on YouTube. Please, like, subscribe, rate, and most importantly, share this public educational good with your friends, your family, your colleagues, and maybe a neighbor down the street. The show was produced by Nicholas Tempte, and we'll see you next time on Money Lessons.