Trading and Exchanges Chapter 25: Internalization, Payment for Order Flow, and Crossing Networks
If you use Robinhood or any zero-commission broker, this chapter explains how the sausage is made. You pay zero commission, sure. But someone is paying your broker for the privilege of filling your order. That someone is a wholesale dealer, and the payment is called “payment for order flow.” Chapter 25 breaks down how this works and whether it hurts you.
What Is Internalization?
When a dealer fills their own client’s order instead of sending it to an exchange, that is internalization. Your broker is also a dealer? They match your buy order against their own inventory. No exchange involved. No public order book.
A related practice is preferencing. Your broker routes your order to a specific dealer who pays the broker for that flow. The broker gets cash. The dealer gets a retail order that is almost certainly uninformed and therefore profitable to fill. You get your trade executed. Everybody wins, supposedly.
Brokers also cross orders internally by matching a buy from one client against a sell from another. The broker collects commissions from both sides. Again, no exchange.
All three practices pull orders away from central exchanges. Harris says traders call this “market fragmentation.” And it raises a real question: is your broker actually getting you the best deal?
The Best Execution Problem
Brokers who internalize or accept payment for order flow have an obvious conflict of interest. They route your order to whoever pays them the most, not whoever gives you the best price. So regulators require “best execution.”
For market orders, dealers claim they provide it when they fill at the national best bid or offer (NBBO). For small orders, some even promise “price improvement,” filling you slightly better than the NBBO. For limit orders, it is harder to define. You mostly care about whether your order fills at all and how fast.
Here is the catch. Most retail traders cannot actually measure execution quality. You know what commission you paid. That is on your statement. But did you get filled at a good price relative to what was available? Most people have no idea. And brokers know this. So instead of pushing dealers for better fills, brokers accept whatever passes as “best execution” and use the payment-for-order-flow money to lower commissions, which you can see and compare.
The Economics: Commissions vs. Spreads
This is the most important part of the chapter. Harris makes a sharp argument about competitive markets.
If the wholesale dealing market is competitive, dealers compete to buy order flow from brokers. If retail brokerage is also competitive, brokers pass those payments to you as lower commissions or free services. Your total cost (spread plus commission) stays roughly the same regardless of how best execution is defined. Demand better fills and commissions go up. Accept wider spreads and commissions go down. The pie does not change, only how it is sliced.
This is exactly the Robinhood model. You pay zero commission. Robinhood routes your orders to Citadel and Virtu, who pay for the flow. Those dealers fill you at the NBBO or slightly better. You feel like you are trading for free. In reality, the cost is hidden inside the spread.
Is this bad? Harris says not necessarily for small uninformed traders. Dealers on public exchanges set wide spreads to protect against informed traders and big orders. But when they cherry-pick retail flow (almost entirely uninformed), the risk of getting burned is low. Payment for order flow lets small traders avoid subsidizing the cost of informed trading.
The Anticompetitive Side
It is not all sunshine though. Internalization and preferencing have a dark side.
When brokers route orders based on who pays the most rather than who quotes the best price, it kills the incentive to quote aggressively. If you are a dealer posting a tight spread to attract orders, but those orders get routed to a competitor who pays more for them, why bother? Your good prices do not attract flow. So you widen your quotes. Everyone does. Spreads get wider across the board.
Limit order traders get hurt the most. When dealers internalize marketable orders, standing limit orders on exchanges face worse adverse selection. They only fill when the market moves against them. The profitable fills get scooped up by internalizers. What is left for the public limit order book is the toxic flow. This shifts power from public limit order traders to dealers.
Internal Crossing and the Big Debate
Crossing networks let brokers match client orders against each other, often at the NBBO midpoint. No spread cost. Lower commissions. Sounds great. The concern is that brokers show orders only to their own clients, not the broader market where someone might offer a better price. They want both commissions, so they have no incentive to look elsewhere. Real estate agents do the same thing: show new listings to their own buyers first, post publicly later.
Harris ends with a question regulators still argue about: would markets be better off with a single consolidated limit order book? Full transparency, no cream-skimming, no hidden payments. But it would kill crossing networks and services that institutional traders value.
Internalization probably helps small uninformed traders get lower total costs. But it weakens central markets, hurts limit order traders, and creates conflicts of interest hard to police. As Harris puts it: the more convoluted a competitive system, the less efficient it will be. And the wholesale-retail order flow system is nothing if not convoluted.
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