Payment for Payment Flow: How revenue sharing agreements impact payment orchestration
Markets that compete on volume often share some of their revenue with their intermediaries
Flash Boys was the fork in the road that led me to where I am today.
The book tells the story of the founders of IEX, and their quest to put out of business those who trade, not on being right, but on being first. It did to quants what Liars’ Poker had done to investment bankers decades before: putting them in the spotlight.
Flash Boys made me want to build a stock exchange.
I picked it up a few weeks ago, and realized there’s something eerily similar in how payment orchestration platforms deal with their clients’ payments.
Here’s the hidden risk of not building payments in-house.
I’m Alvaro Duran, and this is The Payments Engineer Playbook. Youtube has tons of tutorials on how to pass software design interviews that use payment systems. But it is dry on videos teaching you how to build this critical software for real users and real money.
The reason I know this is because, in close to a decade dealing with payments systems, I’ve had all types of interesting conversations about what works and what doesn't behind closed doors.
It’s time we have these conversations in public.
In The Payments Engineer Playbook, we investigate the technology that transfers money. All to help you become a smarter, more skillful and more successful payments engineer. And we do that by cutting off one sliver of it and extract tactics from it.
In today’s article, we’re establishing a link between high frequency traders and payment orchestration platforms, and what that means for the merchants that engage their services.
Black Monday was a bad day to be an investor. But it was bad for brokers too.
The moment they realized what was happening, most just stopped answering their phones.
People still argue what triggered the events on the stock market on that day, 19 October, 1987. But the fact is that, for some reason, investors were in a rush to sell, way more than they wanted to buy, all at once.
In the aftermath, regulators decided to take action: investors could never be hung up ever again. They put in place a bunch of rules that ended up encouraging investors to trade not by means of humans, but computers.
By the 2000s, machines were front and center of virtually all trading activity.
Replacing humans with computers reshaped what the “stock market” is, but most people still have an outdated vision of men shouting and wearing ridiculously colored jackets.
Otherwise, why is Bloomberg TV still showing a continuous stream of stock quotes?
The reason these charts and these numbers no longer matter is because computers have pieced down the stock market into millions of parts.
And that has created an interesting dynamic that has some parallels to payment orchestration.
And that, in the stock markets, is called Payment For Order Flow.
Payment For Order Flow
I’m sure you know that most brokers don’t charge any commission to let you buy or sell shares in the stock markets. You probably guessed that they don’t do that out of the goodness of their heart, but because it makes business sense to them.
The reason your online broker doesn’t charge fees is because they’re being paid by someone else.
Rather than submitting your order to NASDAQ, or NYSE, or whatever, they’re passing it to another firm called wholesaler.
You may know them by another name: high frequency traders.
This is another broker, but larger. One that gets orders from your broker and from other brokers, and has the ability to match your order with another in its inventory, without having to go to an exchange and paying any fees to them.
It’s peer-to-peer, so to say.
What is shocking to most people is that wholesalers almost always offer a better deal than stock exchanges themselves.
In fact, the exchanges’ fees are so high, wholesalers can profit, even when they offer a so-called price improvement over the NASDAQs and NYSEs.
There are two reasons for this: the Good and the Bad.
The Good Model goes like this [...] Look, we hate trading with all these hedge funds on the public stock exchange. So much adverse selection. If we could just trade with your delightful retail customers, who trade small lots and never know anything we don’t know, we would never lose money. So we could afford to charge them a much lower spread.
The Bad Model goes like this [...] only naive rubes pay those posted prices. Look. Instead of sending your customers’ orders to the exchange [...], send their orders to us. We’ll give them a better price [...] It turns around and buys stock at the real price, [making] instant risk-free profit.
— Matt Levine, What Does Payment for Order Flow Buy?
The Bad Model is the point of view of Flash Boys. It’s an inaccurate view of US equity markets, because both models are true to some extent.
But a useful one.
The Good Model is true when the wholesaler can’t find a matching order immediately, and is forced to hold your order in its inventory.
The Bad Model is true when the wholesaler has already found a matching order, and is able to take it away from the market before anyone else.
Speed matters.
But none of this is possible without sufficient scale. That’s why, to ensure that enough orders are coming their way, wholesalers pay your broker for the convenience of routing your order to them.
That’s what’s called Payment for Order Flow.
Agency Risk and Reward
Something similar happens when, instead of brokers routing trading orders, it’s platforms routing payments.
Every time a merchant requests a payment, there’s a decision to make: which PSP offers the lowest fees? The best likelihood of approval? The highest chance to go around SCA?
These are questions that can realistically be answered only at scale. Having more data is the way to answer them.
Which is why many merchants turn to platforms for advice.
Just like wholesalers, PSPs compete on volume. That’s why they’ve recently engaged in similar practices: platforms often receive a rebate when they route your payment through the paying PSP.
Which doesn’t mean it isn’t a good choice. But it should make you think.
Money, be it by means of trading orders or customers’ payments, is ripe for conflicting interests. That’s why, the moment you decide to engage the services of an external company, there’s always a risk.
The risk that their interest won’t always be aligned with yours.
Revenue agreements between platforms and PSPs are risky, but they aren’t necessarily bad. Like the Good Model, it allows them to pass some of those savings to their clients.
But it also diminishes their credibility.
At the end of the day, it’s one more risk/reward trade-off. But the biggest risk of all is to go about your business pretending that this risk doesn’t exist.
This has been The Payments Engineer Playbook, I’ll see you next week.
PS: I’ve been hesitant to share this piece of news, but I believe it’s about time.
In 2025, the subscription price for The Playbook will be $20 monthly, $199 annually.
But for now, you can pledge your support for the newsletter, and you’ll be able to subscribe for $15 or $149, respectively.
I will not make you switch to the new prices when the new year arrives. All pledges will be grandfathered to the 2024 subscription prices.
But only if you pledge a subscription before the end of the year.
That’s 48 days—no need to be a high frequency trader to make the deadline.
Let me remind you that most companies have a training budget for their employees. If you need approval from your company, better hurry up before the window closes.
And if someone you respect shared this article with you, do me a favor and subscribe. Every week I feel I’m getting better at this. That means that my best articles on how to build payment systems are probably yet to be written.
You can only find out if you subscribe to The Payments Engineer Playbook. I’ll see you around.