What are market makers and how do they impact stock prices?

Market makers are intermediaries that buy and sell securities to provide liquidity on the market. In the US, market makers are mandated to execute securities at, or better than, the national best bid offer price (NBBO). When your order is executed at a better price, it’s called a price improvement. This NBBO is a reference to the prices on public exchanges and we can interpret the price improvement as the amount better than you would get if your order is executed on an exchange. 

While this all helps the market to flow, how do market makers actually make money? The market makers earn revenue from the spread, which is the difference between the bid and ask prices. 

The bid price is the price that they’re willing to pay for your shares, while the ask price is the price that they will sell them. Naturally, this latter price will be higher.

The profit here (known as the ‘spread’) may be as little as a couple of cents, but with millions of trades each day, this can add up to profits of hundreds of thousands of dollars each day.

So, how does this matter to investors? Ultimately you’re probably never going to deal with a market maker directly, but your broker will, and they receive a small payment for directing orders to market makers. This is known as ‘payment for order flow’, or PFOF.

So, which brokers are making the most money from PFOF received from market makers? Interestingly, the answer varies a lot from one broker to another, so it’s an important consideration to make when comparing brokers.

Analyzing SEC 606 reports from 2020-21, a total of $2.27 billion was paid to the 12 brokers covered in the analysis, for directing trades to market makers.

TD Ameritrade is the broker that made the largest revenue, with just under a billion dollars in total, followed by Robinhood, one of the market leaders, with PFOF revenue of $532 million.

However, not all brokers profit from PFOF so much. In fact, Fidelity and Vanguard don’t earn a penny through PFOF.

Why does payment for order flow matter? It’s because market makers can discriminate among brokers and could provide more or less price improvement based on the negotiation or deal between brokers and market makers. This means that if your broker has a deal with market makers, you as an investor will likely get a smaller price improvement compared to using a broker that doesn't have a deal with market makers.

Next, we took a look at which brokers are most likely to route your trade to a market maker and which are more likely to send you to a public exchange.

A number of brokers, including Robinhood, direct 100% of trades to market makers, alternative trading systems (ATS) or other execution firms.

Unsurprisingly, these firms are often also the ones that have the highest PFOF revenues, with Robinhood receiving half a million dollars in PFOF in the period analyzed. 

On the other hand, for a broker such as Interactive Brokers, which made a total of $12 million, and Fidelity, which earns nothing at all through PFOF, only 19% and 60% of orders are directed to market makers, respectively.

*Non-directed orders mean that orders not directed (by the client) to a specific trading venue, that are then directed (by the broker) to market makers.

So who exactly are these market makers, and how much are they paying for the opportunity to trade your shares?

Again looking at SEC 606 reports from 2020-2021, Citadel emerges as the dominant player, paying out $2.6 billion in PFOF, which accounts for 39% of total PFOF payments in the period.

The second biggest market maker is Susquehanna (G1X | Global Execution Brokers), which paid a total of $1.5 billion in PFOF, followed by the likes of Virtu and Wolverine.

Comparing 10 high-capitalization and meme stocks, we can see that Citadel and Virtu executed the most shares among the analyzed four major market makers.

For example, Citadel executed more than three times more shares than G1X and more than six times more than Two Sigma.

All data sourced from SEC 605 and 606 reports and refer to the period of 2020-2021.