The term "front-running" is terribly misused in these discussions (I can't tell from your short comment if you were, though). You "front-run" someone if they reveal their trading intent to you, and front-running usually involves an agency problem (ie, your broker and their responsibility to you as a client).
About liquidity providing... brokers don't generally route orders directly to an exchange. In most cases your order will get routed to a 3rd party liquidity provider, a firm who agrees to buy at the bid and sell at the ask and do so quickly. Often, these guys will pay the broker for order flow or price-improve your order to capture all of it, or both. Competition between these firms goes a long way towards guaranteeing the NBBO price that your broker is obligated to provide.
Connecting the dots leads you to a conclusion that the order flow is valuable enough to them (for purposes of their own prop trading, strategic option selling, etc) that they act as market makers.
> In most cases your order will get routed to a 3rd party liquidity provider,
This is only true if you are a regular person, ie using IB to buy in your rrsp or ira account. Almost exclusively, anyone who is a professional will go direct to market( DMA). They will never go through Citadel or some other liquidity provider.
> Often, these guys will pay the broker for order flow
Not often, always. They always pay for this, there are no freebies:)
> a firm who agrees to buy at the bid and sell at the ask and do so quickly.
If you can find someone who will guarentee that they will fill my buy orders at the bid and sell orders at the ask, please let me know and I'll give them all my flow:)
> Competition between these firms goes a long way towards guaranteeing the NBBO price that your broker is obligated to provide.
What does this even mean, even without someone buying your flow you are still guaranteed to get the NBBO price, RegNMS says this is the law. Let me be clear, 3rd party brokers have no part in guaranteeing you get the NBBO price. The law says if your order can trade at the NBBO, it must.
1. Brokers don't only send orders to 3rd party market makers because they're being paid for order flow. You're right, they won't get order flow for free, but I didn't mean to imply that they did.
2. Quoting and buying at their published bid/ask is precisely their function. Possibly we're just disagreeing on terms. The SEC's website is fairly good at explaining this flow. http://www.sec.gov/investor/pubs/tradexec.htm
3. What I'm discussing is the actual mechanism for HOW nbbo is fulfilled. Competition in the marketplace -- third party market makers and arb firms -- absolutely play a role in ensuring the efficiency of the market. If brokers had to run this infrastructure themselves, it would be non-trivial and without any financial incentives that I can think of.
I think he was making a little joke about this. He said:
fill my buy orders at the bid
and sell orders at the ask
Of course, that wasn't what you originally said, which was
a firm who agrees to buy at the bid
and sell at the ask
[1] http://en.wikipedia.org/wiki/Knight_Capital_Group#2012_stock...
Historically, in the HFT world, it also involved getting ahead of big orders in the order book by taking advantage of how orders are systematically queued or prioritized.
I have no idea if this is still an issue (doubt it), but it was in the early days of HFT. Anyway, I'm out of my element...'Dark Pools' is a decent read if you're into this stuff.
Right, but the inverse isn't true. Not all liquidity is speculative. And third party market makers are surely making money from providing liquidity but not by taking the other side of a trade.
But the firms that do play liquidity -- the firms that compete with one another for your order after it comes thru your broker -- aren't hurting anybody by front running. In fact, they value your order flow so much (for their own info) that they price-improve for you so they capture more/all of the order. IIRC over 60% of stock trades are price-improved.