The Spread Explained
A market maker continuously quotes two prices for a security: a bid (the price at which it will buy) and an ask (the price at which it will sell). The ask is always higher than the bid. When a retail investor buys at the ask and another investor sells at the bid, the market maker has facilitated two trades and captured the spread between them. On liquid, large-cap stocks, this spread may be only $0.01–0.02 per share, but multiplied across enormous volume, it generates substantial revenue.
Volume as the Business Model
Citadel Securities' revenue comes not from any one trade but from the cumulative spread across billions of trades. The firm reportedly processes hundreds of millions of trades per day. Even at razor-thin per-trade margins, the total revenue from market-making at this scale is in the billions annually. This is the economic logic of scale in market-making: the firm that can handle the most volume with the lowest per-trade costs wins.
Adverse Selection Risk
Market makers face a structural risk called 'adverse selection': the risk that the investor taking the other side of a trade has information that the market maker doesn't. Informed traders will disproportionately buy when prices are about to rise and sell when prices are about to fall — which means the market maker systematically loses to informed traders. PFOF is partly designed to select for uninformed retail order flow — the type least likely to impose adverse selection costs — rather than institutional or informed flow.
Who Ultimately Pays
The economics of market-making can appear abstract, but the ultimate source of market maker revenue is identifiable: it is the aggregate of all retail investors' trading costs embedded in the spread and execution quality they receive. PFOF payments are funded from these revenues. In The Ethics Reporter's view, making these economics visible to retail investors is an important function of financial journalism.