why was the order flow of retail brokerages worth hundreds of millions of dollars per year to these HFT firms?
Order flow from retail brokerages can be assumed to be "non-directional", which means that it comes from people who are buying or selling for some reason other than "I have better-than-market knowledge of information which will shortly be relevant to this stock."
One extremely important example of directional order flow is when you have the knowledge "100k shares of this stock are shortly going to be shopped on various exchanges" because you're doing the selling. This will typically cause price impact (i.e. the price of the stock declines), meaning that market makers who take your first few hundred/thousand shares are going to get shellacked. They generally don't love this.
In the (virtually guaranteed) absence of directional order flow, market making is a license to print money. Both sides pay you the spread and you don't accumulate much inventory risk. (i.e. You buy, you sell, you sell, you buy, and you're rarely left with a meaningfully sized position in either direction which would expose you to the stock at issue.)
That's why you pay for non-directional order flow. It's like leasing a toll bridge.
It does seem like the fee being paid for order flow should be able to be captured by those making the orders in the form of further reduced spreads rather than by brokerage firms selling the flow. Though perhaps the issue is that with stocks regulated to trade in penny increments that's hard to do?
Order flow from retail brokerages can be assumed to be "non-directional", which means that it comes from people who are buying or selling for some reason other than "I have better-than-market knowledge of information which will shortly be relevant to this stock."
One extremely important example of directional order flow is when you have the knowledge "100k shares of this stock are shortly going to be shopped on various exchanges" because you're doing the selling. This will typically cause price impact (i.e. the price of the stock declines), meaning that market makers who take your first few hundred/thousand shares are going to get shellacked. They generally don't love this.
In the (virtually guaranteed) absence of directional order flow, market making is a license to print money. Both sides pay you the spread and you don't accumulate much inventory risk. (i.e. You buy, you sell, you sell, you buy, and you're rarely left with a meaningfully sized position in either direction which would expose you to the stock at issue.)
That's why you pay for non-directional order flow. It's like leasing a toll bridge.