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That document is mostly conspiracy nonsense. Wholesalers don't need to push the price around to make money. Most retail trades are tiny, uncorrelated with future order flow, and don't have short-term alpha behind them. The wholesaler will make money filling them at the NBBO with a small improvement and holding the delta. When you can't be hit by hedge funds slicing their massive order into a million pieces, HFT quant algos or arbitrage traders, and don't have to compete to be first in the FIFO queue, making money buying the bid and selling the offer is easy money.

That was my intuitive reaction to that Nanex post as well, but I didn't see how I would handle the rebuttal that doing stuff like Nanex talks about would make internalizers or wholesalers more money.

Wholesalers have agreements with retail brokers to provide a certain level of "execution quality", and that's what they compete on (fiercely). If they pushed the price around on one order, they'd have to make it up on some other order to meet their obligations. It's measured against NBBO at order receipt time, so chollida1's example would count as negative price improvement (even if the best offer was only showing 100 shares and not 2000).

This sequence of events is wrong. Here's how it goes:

0. The internalizer tells the brokerage that they want to buy 2000@$10.03.

1. Customer places a buy order 2000@$10.03.

2. Brokerage looks at the internalizer and at the NBBO. Brokerage realizes the NBBO is better than the internalizer and so routes a 700@$10.02 to the public markets as per their legal obligation due to Reg NMS.

3. Brokerage routes the remaining 1300 shares to the internalizer, where they are filled at $10.0290.

Customer trades are 300@$10.01, 400@$10.02, 1300@$10.029, resulting in (as you noted) a price improvement to the retail customer.

The only this doesn't benefit the customer is if (as kasey_junk notes) the brokerage is using an incorrect NBBO. If you believe a brokerage is doing this please report them to the SEC for violating Reg NMS.

Right, so the reason all these banks run extremely expensive HFT divisions is to guarantee the best possible price to their customers. Got it. I'm glad they have our back! /s

As someone who has actually seen the scenario described above play out, I'm not so sure: stock doesn't move for minutes at a low volume time of day, the moment I place my limit order the price is suddenly higher than my limit; rinse and repeat. I've seen this happen enough times to make me believe Reg NMS is just another regulation they've found a plausible deniability around (BTW, before you tell me "prices going up when you place a big order is how the market works", I've tested this with 100 share orders, so there was no order split going on. I still got priced out.)

I think everyone is right to be suspicious of payment for order flow, on the surface it does seem hard to get the incentives right.

That said, in your scenario (you were prevented from trading) how does anyone make money? You were (probably) paying for a trade (which did not happen) and you were using infrastructure that costs money (placing orders), and no one was able to trade against you. That is not a great business model...

Also, none of the groups we are talking about are banks.

My guess is that the algorithm doesn't expect to make money out of that particular order, but rather guesses this is a bigger order that is being split (laddered if you will) into multiple small orders at different acceptable limits. The product I used (Interactive Brokers interface) offers that laddering strategy as an option when trying to make big purchases.

Oh, and BTW, order cancellations cost money. Cents, sure, but when you are making money on a 1c spread, you would also benefit from a 1c cancellation.

Other than that, I've been tempted (and many times succumbed) to raise the limit just to get that trade. And then you see the price go up again before your order goes through. It'd be hilarious if it wasn't infuriating.

Just chiming in to point out that 'yummyfajitas, 'chollida1, and 'kasey_junk are all current or former trading engineers.

I imagined as much. That's what I love about HN, you do get some details on how the sausage is made from the sausage-makers themselves.

My guess is that the algorithm doesn't expect to make money out of that particular order, but rather guesses this is a bigger order that is being split (laddered if you will) into multiple small orders at different acceptable limits.

If the order is coming from a retail brokerage that's a terrible guess - how often do you think someone goes into ETrade and tries to move $20M of GOOG?

Big orders come from institutional investors. Those are explicitly the orders that market makers are trying NOT to trade against, and that's why they try to buy order flow. Order flow is known to come from players who aren't making big orders.

As I clarified on the other comment, I meant "big" as in "retail big" (i.e. a couple thousand shares of TSLA, or any order big enough to be fulfilled by matching several sell orders.) I can't really recall that many of my orders being filled below my limit price, unless I was willing to increase the limit by a few cents over the NBBO.

If the ask price for a security is, say, 5.51 and I put my limit at 5.51 the chances of getting the order filled were pretty low. If I was willing to go to 5.53 the chances would increase, if the order was 5.55, I'd probably get a fulfilled order at an average price of 5.53 or so. Not a huge difference on small orders (say 1000x2c = $20) but enough to make a "big" volume, small spread strategy pretty much useless.

The price can change from the time you place your order to when it arrives at the broker. This is especially likely if you are an active trader chasing news or momentum where others are likely trying to buy at the same time. It's like aiming a rocket, or in your case, an old Honda Civic, at a fading star. Have you looked at what the book state was after you placed your order in the cases where you don't fill? If you have a working order priced through the market that's unfilled, take a screenshot and name & shame your broker here.

Suppose you place a limit order to sell STCK for $x and I only execute it (giving you $x) if the price goes above $x+1. Someone's making $1 on that spread and it definitely isn't you.

If I accept a limit order from you to sell for $x and the price goes down to $x-1, someone lost $1 and it sure wasn't you.

All you've discovered is that when you sell a stock, you lose both the upside and the downside.

No, the broker can just not execute the limit order. There's never downside for the market makers.

You are confusing "accept a limit order" with "purchasing a call option".

Once you've accepted the order you are legally obligated to deliver in T+3 days. If you fail to deliver you pay big penalties, your broker shuts you down, all sorts of bad things.

In my experience with brokers like Schwab, placing a limit order is no guarantee of execution, even if the market price reaches the price specified in the limit order.

I think you're again confusing terminology; you're referring to placing an order, which is obviously no guarantee of execution, and Chris is referring to what happens after your order is executed.

They don't. They run them to make a profit off the spread.

The purpose of order internalization is to trade against uninformed participants (Joe 401k), without risk of accidentally trading against bigger informed players (Bill Ackman). If you are trading against uninformed players, your risk is lower and you need to offer a better price to get order flow.

Read these two blog posts for a bit more detail on price discrimination on the basis of delta toxicity (albeit not in the order internalization context).

https://www.chrisstucchio.com/blog/2014/fervent_defense_of_f...

https://www.chrisstucchio.com/blog/2014/mark_cubans_hft_idio...

If you want to argue that something nefarious is going on, go ahead and describe the mechanism. But whatever it is, it's almost certainly not the mechanism chollida described.

I have no idea what the mechanism is, but there's definitely something extremely fishy when you don't see the NBBO move at all for an hour and it magically moves the moment you place an order. I wouldn't even know who is to blame: Interactive Brokers? Other HFT players? My incredibly consistent bad luck at placing an order at the exact same moment the price goes up, even after observing the price being stable for an hour (again, at a very low volume time of day, like 3pm PST)?

I clearly don't understand what's going on under the table as well as you would, and because the strategy I was toying around with at the time was basically big volume on small spreads ("big" for a retail guy, obviously, I don't have millions at my disposal) it was shot to crap by these magic changes.

So I did the sensible thing and closed my account. Off to invest in less volatile assets, if I can find any, heh.

How is step 3 not front running? It would appear to be the very definition; the wholesaler is executing an order before yours, without your knowledge, that will affect your order.

Is there an order option to prohibit wholesalers from trading before you?

Because the broker isn't doing the front running. That's why it isn't the currently illegal kind of frontrunning. They sell the data to other participants who have faster internet connections than you.

Basically any time you send a "smart" routing order, it is actually the least smart thing to do (unless you REALLY need the liquidity). Your trade order gets sent to all the exchanges, and ah I don't really feel like explaining it.

tl;dr Someone intercepts your data packet to one exchange, and alters the liquidity on the other exchanges, so you get a partial fill and then adjust your order at the slightly worse price.

>Because the broker isn't doing the front running.

In the scenario presented, the wholesaler receives your order, then executes its own orders, then fills your order based on its own executions (which you are unaware of).

The wholesaler is required by law to meet or beat the NBBO --- the "exchange price". If you took your tiny order directly to an exchange, you would not fare better.

The defense is that this behavior is legally sanctioned front running?

How can a wholesaler guarantee the exchange price in the face of disappearing orders?

I don't think they can. Instead, the wholesaler fabricates an order at the limit of your order, then reports the sale to you.

Edit: [rate-limited] Reply to tptacek comment below:

> I can't even tell if you're talking about market or limit orders.

Can you view the context of this thread? I am talking about the explicit steps listed in the comment I first replied to. Specifically, step 3 [0].

In chollida's description the orders are limit.

Step 3 appears to be, exactly, front-running as explained in my post [1] immediately above this one.

I asked if anyone could explain how that behavior was not front-running. You responded; indicating that the behavior was according to regulation.

You claim that the wholesaler must give you the best "exchange price", but I claim that such a guarantee is generally impossible to fill (time-distance-information problem), and that in the specifics of chollida's described scenario, the wholesaler is actually front-running you by examining your unfilled (limit) order and then filling it at the limit (as in, calculus) with it's own fabricated (perhaps, synthetic, but front-ran, nonetheless) order.

If such a guarantee is generally impossible, then the wholesaler must be cheating, the law is incompetent, or, both.

[0] https://news.ycombinator.com/item?id=11668835 [1] https://news.ycombinator.com/item?id=11669193

I don't understand any of these three sentences. Can you reformulate your argument as a sequence of events, like:

T0: Bob->Schwab: Market BUY 100 ISSX

T1: Schwab->Citadel: Forward Market BUY 100 ISSX

... and so on? I can't even tell if you're talking about market or limit orders.

If you place a limit order, you're guaranteed that any execution you get will be at least as good as your limit. That's the point of a limit order.

You aren't entitled to a better price than your limit. If you think you are, can you provide a sequence of trades in which someone else captures a premium where they don't take downside risk?

I don't see how taking on downside risk improves the wholesaler's position (in fact, I think the rationalization is an even more degenerate case).

The fact still remains that the wholesaler has fabricated an order on the knowledge of a customer's pending order, which affected the execution price of the customer's order, before the customer could even know that it happened.

Even if the wholesaler sent their order to an exchange and still matched with their customer, it is still front-running, as the wholesaler is using knowledge of their customer's order to, essentially, eliminate all possible price improvements.

So, what is being called a "limit order" is just code for "we might just fill your order at your limit [when there are no market orders], if we think we can make money off [front-running] your order with our own".

It would perhaps be acceptable if the wholesaler offered some kind of kick-back on any profits made, but that would need to be a different kind of order and I'm not aware of anywhere that does it.

Your broker or the wholesaler both have a choice:

1) match the order with the NBBO. 2) send the order to the exchange.

If your limit is better than the NBBO, then they are required by the law to price improve it. Further, the nature of their agreements with your broker are such that they are required to maintain a price improvement level (that should be better than NBBO compliance). That is, incidentally also largely the requirement the exchanges operate under as well.

A limit order doesn't have anything to do with the existence or non-existence of market orders, it has to do with your limit and the NBBO. The way they make money is not by changing the market against your interests, but instead booking the spread (and in fact the reason they like retail order flow is that it is naturally uncorrelated so the spread is more even).

The customer does in fact know that this is happening as it is a regulatory requirement that they disclose it.

I suspect that lots of whole sellers would be happy to kick back profits, if the retail customer was also on the hook to back the losses. Instead, they aren't and they get heavily discounted (to the point that it is now free to trade) trading costs instead.

This is all hand-waving. Neither you or tptacek have altered the fundamental reality:

>In the scenario presented, the wholesaler receives your order, then executes its own orders, then fills your order based on its own executions (which you are unaware of).

>The way they make money is not by changing the market against your interests,

Oh, but they do. They fabricate an order in response to yours. If they did not act, your order would not have filled at $0.001 under your limit.

>but instead booking the spread (and in fact the reason they like retail order flow is that it is naturally uncorrelated so the spread is more even).

You can call it whatever you want, the wholesaler is manipulating the market to their advantage. The wholesaler knows the price is likely to improve, so it arbitrarily truncates your order and infills its own account with the improvements.

Likely is the important part of your final sentence. They are not acting against your interests and they are taking on risk in the market to your benefit.

Is it limited risk? Of course, that's their job.

Finally, I'd ask, what is your point? That the law is flawed? OK, then work to change it. But know that lots of people have done their own research and come down in favor of the execution cost benefits of wholesellers.

>They are not acting against your interests

Of course they are. Had they not acted, you would have had a chance at price improvement. Instead, they took your chance for a token payment.

How?

https://news.ycombinator.com/item?id=11667688

I'm going to suppose that your response is fixated on:

> Wholesaler sells short remaining 1300 shares at $10.0290

whereby the wholesaler takes a speculative position wrt the original order?

Are you suggesting that the wholesaler giving you 0.0010 profit on your trade guaranteed, is working against you? Without regard to your execution costs?

Can you suggest a single chain of messages where you make money on that trade? What are the chances where that chain of messages is likely?

Yes, I am talking about where the wholesaler fabricates in order in response to your order. Such behavior is front-running, by definition.

The wholesaler is making off-market trades and treating them as if they are on-market. The wholesaler would not trade, if it did not think it would profit. The wholesaler's profit is the difference between their buy-price and what they actually paid you.

Are you suggesting that if the wholesaler wasn't interdicting orders the average price improvement for these orders wouldn't be close to the average profit the wholesaler makes on each instance of such a trade?

In the example above, if they had not filled your order at the price improved price, it would have either filled at the higher price, or rested at the higher price. In either case you get a higher price.

They do this because they are taking on the risk that the market will eventually allow them to work out of their short position at a better price than they paid you. But they don't know that it will do that.

One of the reasons they pay for retail flow is that it on average goes back and forth, making it more likely that this trade works to their advantage.

None of the profit of that trade came from you the limit order provider. It came entirely from the average spread.

>In the example above, if they had not filled your order at the price improved price, it would have either filled at the higher price, or rested at the higher price.

Or, you know, improve beyond the $0.001/sh the wholesaler paid.

No, it wouldn't have. That's the point of why they improved you. By that point there was no one else available to do it.

So, you wait around for an order at your limit or better. There is nothing that says your limit order must fill, even if no on is available.

It won't be better, that's not how it works.

At the point that they filled you at 10.299, the market is set at 10.30. 1 of 2 things can happen. Either there is enough volume to fill you at 10.30 that your order is fully filled at 10.30 (worse than the wholesaler gave you) or there isn't and some of your order fills at 10.30 (worse than the wholesaler gave you) and you have now set the new market level and rest your order. Once your order rests, it will not be improved and will either fill at 10.30 (worse than the wholesaler gave you) or it will be cancelled (you didn't get what you wanted).

Most people placing a limit order like that would prefer the outcome that the internalizer provides, if you don't, great use a broker that allows you to route direct. But its certainly not front-running because the internalizer acted directly in your stated interests, not against them.

> The wholesaler is required by law to meet or beat the NBBO --- the "exchange price".

Then again, this discussion is on a thread about the US DoJ investigating wholesalers for potentially breaking the law when it comes to what price the required to provide (though apparently a different requirement than the NBBO, specifically, the "best execution reasonably available".)

A legal requirement doesn't mean its going to happen in practice, it means that there is, at least in theory, a remedy available if it doesn't.

(Then again, not meeting or beating the NBBO seems a bit more obvious than not providing the best execution reasonably available, so I'd be somewhat more surprised if this wasn't happening simply because it would seem hard to get away with except in some extreme edge cases.)

Some brokerages allow you to set your routing preference. You will pay more for those brokerages orders.