After speaking with several experienced traders, one thing stands out as top of their wish list: limits on payments for order flow. Payment for order flow (POF) is a widespread arrangement, and one that’s been around in US Markets for quite some time. In fact, this practice dates back to the 1980’s with masters like the notorious Bernie Madoff leading the way. This system is an arrangement where a third-party firm pays brokers to send orders to them rather than to the open market.
The POF firm takes the order and either executes it themselves, or passes on it and sends it to the market to fill against existing quotes. POF firms love retail trades, as the typical retail investor has limited knowledge of the market and its workings, they are relatively uninformed, and they do not see true real-time prices in the market.
When this transaction occurs, the broker-dealer is obligated under Rules 10b-10, 606, and 607 under the Exchange Act to disclose the arrangement to the customer, and in public quarterly reports. They are additionally recently required to execute the trade with the “best execution” and at the best price according to the NBBO. This is where there could be a conflict of interest. Some exchanges offer different Maker-Taker pricing models, providing incentive to some brokers to not only look for the best price under NBBO, but also the best rebate available to them. In simple terms, the Maker-Taker pricing model exists at most exchanges when two different costs exist – one for the party providing the liquidity (the “Maker”), and the party removing the liquidity (the “Taker”). Generally, the Maker gets paid a rebate, and the Taker has to pay a fee, although some smaller exchanges flip this model to draw Takers instead.
If a retail customer places an order to an online trading venue from their living room couch while watching the news, they may stipulate that they’d be willing to pay up to $10.10 for a share of XYZ stock. The firm buying the orders sees what they want, and can see that the NBBO (National Best Bid and Offer) is $10.09 x $10.10. At this point, they can pass the order directly to the public markets and buy the $10.10 offer or, more likely, sell the stock to the customer themselves, usually at $10.0999 to give the appearance of improving the execution in return for jumping ahead of every other offer at $10.10. They are now short from just inside the bid and can possibly take advantage of midpoint pricing on dark pools to buy it back at $10.095.
Further, firms paying for order flow are using the much faster direct feeds to see the market a fraction of a second before it is represented in the NBBO. In this example, it’s possible the market has already moved to $10.08 x $10.09. If the NBBO is still showing an offer at $10.10, they can give you the execution at $10.10, which is the best official offer price, and immediately buy the $10.09 offer they know is coming.
Even when the market makers see an opportunity to buy and sell within a sub-penny difference, do not be fooled, this is a multi-billion dollar industry available only to the select few.
This hurts the average day trader because once the POF firms process the uninformed retail customer orders, the informed flow that’s left is all that’s available for the exchanges to absorb and trade. Furthermore, daytraders trying to sell stock at $10.10 in the above example act as nothing more than a reference price for firms that get to see the orders first. The only way the daytrader gets to sell at $10.10 is if the firm seeing the order first decides not to sell it themselves, which likely means it’s no longer a good trade.
The SEC has taken an approach based mainly on disclosure, when it comes to payment for order flow. Even according to Rule 10b-10 that requires broker-dealers to indicate on the customer’s statement that a payment for order flow arrangement exists, they are not obligated to offer up information on the source or nature of the compensation they received under this deal, unless the customer submits a written request. One could wonder just how many retail investors are reading the fine print and sending a written letter (do people still do that?) to the brokerage house, asking for more details of their payment arrangement, and it is highly doubtful they are reading their quarterly reports.
A Trader’s Wish
This leaves the average trader wishing for LIMITS on Payments for Order Flow. Rather than just ask for disclosure let’s look closer at this arrangement; the implications to the investor, the implications to the market and all traders, and just how is this benefitting the broker and POF firm? The benefit to the broker is clear – the cost of executing trades for their customers is no longer an expense, it’s a profit center. The bigger question is how it benefits the firm paying for the order flow. There is clearly an advantage to getting a first look at orders before the market does (otherwise, how could these firms pay for that flow and still make a profit on it?), but does that come at a cost to the investor or the market as a whole?
This topic has received a lot of high-profile attention as some US Senators like Carl Levin have called for an outright elimination of the practice. We couldn’t discuss the topic without mentioning Michael Lewis and his book “Flash Boys” as of course he has drawn widespread attention to this and many other questionable practices on Wall Street.
We could take note of our neighbors to the North, as Canada has done exactly what opponents have been squawking about – eliminated Payment for Order Flow altogether. While Canada has experienced a learning curve with new rules, they are finessing the bumps and finding creative ways to create a more level playing field. One corollary to this is Canada’s use of the Trade-At rule, which requires broker-dealers to execute against the best price in the market rather than just using it as a reference price to execute it themselves. The SEC has been studying that rule as well, and it is another that would benefit daytraders, so put that one on your wish list, too!
If you are an experienced, hard-working trader frustrated with your ability to get quality executions, Limits on Payment for Order Flow is probably high on your Wish List.
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