How Flow Traders Earn Spreads by Internalizing Client Orders
Summary
The document explains how a firm handling client orders can earn a spread through inventory matching, market execution, or a combination of the two. Its example considers a client buy order: the firm may sell shares from an existing position at a price better than the public offer, or fill part from inventory and buy the remainder in the market. The examples show how the firm’s average entry and exit prices determine the spread it captures.
The discussion distinguishes this approach from simply selling direct market access and argues that internalization can benefit a client through price improvement without frontrunning. It also describes a market structure concern: keeping orders off public venues may reduce competition and price discovery, potentially leaving clients without a better price that a public market maker might have offered. The examples are simplified and do not account for costs, adverse selection, inventory risk, or changing prices. A cited FX order-flow study is mentioned but not discussed in detail.
Key ideas
- Flow traders can earn a spread by matching client orders against inventory.
- A firm can combine inventory with market purchases to fill an order and manage its net exposure.
- Internalization may provide a client with a price improvement while still generating revenue for the firm.
- Keeping client flow off public venues may reduce competitive price discovery.
- Inventory risk, execution costs, and adverse selection are not quantified in the examples.
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# How do firms make money from "flow trading"? # How do firms make money from "flow trading"? Apologies if this is a very simple question, but how exactly do firms make money from "flow trading"? Is it simply profiting from "selling" direct market access? ## Answer by madilyn (score 21) https://quant.stackexchange.com/a/36646 Flow trading is in spirit very similar to market making - such firms make a profit by earning a spread. There are 3 common ways this is done. Suppose a client wants to buy 100k shares of XYZ, which is publicly quoted at 1M@10.01 bid, 1M@10.03 ask. For sake of simplification, assume sub-penny pricing is not accepted in the jurisdiction where XYZ is listed. - Match against inventory: The firm already has a position of 100k shares of XYZ at an average fill price of 10.015. In theory, the firm has an unrealized loss at liquidation price on the public market. Now, the firm can sell all 100k shares to the client at 10.02, which is an improvement over the public best offer of 10.03 for the client, while the firm also collects a spread of 0.005x10^5=$500 - a win-win situation. - Combination of the above: The firm already has an inventory of 80k shares at an average fill price of 10.01. It can sell 100k to the client at 10.02 and simultaneously buy 20k from the market at 10.03, thus realizing an average entry price of 10.014 and average exit price of 10.02, collecting a spread of 0.006x10^6=$600. (1), (2) and (3) suggest that all previous replies to your answer are misinformed, it is entirely possible to do this in a way that neither frontruns the client nor disadvantages the client relative to NBBO. On the contrary, the client may be a noise trader and frontrunning its order may actually work against you. (1) suggests that the firm needs to already be in the business of holding on to a large portfolio which it wants to be at net zero exposure, this is why many flow trading firms are also large broker-dealers. (2) suggests that the flow trader collects profits at the expense of the otherwise market makers who were quoting 10.01-10.03 and would've loved to compete for the business of filling those 100k shares. The moral issue arises here as one may argue that the flow trader is collecting its profit at the expense of its client: perhaps a high-frequency market maker on the exchange would've been willing to cross the spread and sell at 10.00 if it saw a 100k@10.00 bid post because the public market maker has prediction alpha. By internalizing the flow, we're removing competitive price discovery from the public market. This lends credence to why most high-frequency trading firms prefer lit and transparent markets, which are more competitive for the utility traders, investors and end users of these markets. ## Answer by rupweb (score 1) https://quant.stackexchange.com/a/36651 As to the value that customer order flow provides, there is specific published research on order flow in the FX markets by Sarno et al. (Why) Does order flow forecast exchange rates?
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