SEC Chairman Says Banning Payment for Order Flow Is ‘On the Table’
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This is the key question.
If we can't demonstrate harm, we have a theoretical problem weighing against billions of dollars in commission savings. If we can show harm, the question would be of the lightest-touch way to rectify that observed issue. Maybe it's banning PFOF, but I doubt it.
~75-80% of Robinhood's revenue is Payment For Order Flow.
And they're paying $5-10 in trading commissions per trade. For the typical retail trader whose order size is in the tens of shares, it's unclear how they're being harmed more than they're benefiting from it (from the free trading fees).
The main difference sounds psychological: "free" trades (with an asterisk) sound like they're designed to encourage people to trade quickly and without much thought. Which can be expensive come tax time, and doesn't encourage the kind of informed feedback that is supposed to keep markets honest.
Which conflicts would those be?
So by definition, the “worst price” would be routing via SIP and execution against NBBO.
The semantics of it (an order has to receive the best price at the time of execution for example) doesn't capture the N ways a fund could make money here and still be compliant.
Instead of worrying about the incorrect definitions used, can you share how firms benefit from order flow instead?
Here’s an example with ridiculously huge spreads but just to help illustrate the issue (in reality, the spreads are fractions of a cent): let’s say the market for AAPL shares is 150 vs 151. A retail trader market sells 100 shares. Absent a dark pool or other internalizer, they will end up hitting the 150 bid. A market maker knows there is a buyer for AAPL shares and expects the 151 offer to trade. The market maker (MM) pays 10c to Robinhood for the order, and buys the shares at 10c better @ 150.10. The MM has paid 150.20 effectively (151.10 + 0.10) when the next best buyer in the market was 150.00. Why would they pay a 20c premium? Because of the buyer I mentioned earlier that the MM believes will buy their shares. The MM turns around and offers these 100 shares for 150.90 (which is 10c better than the best current offer of 151.00) and a hedge fund immediately snaps those shares up.
So what’s the net outcome? In this case, the trader has gotten a better price, Robinhood has received revenue and can offer their service for free, the MM has made a 70c turn on the trade (150.90 - 150.20) and the hedge fund buyer got a 10c better price than was available to them in the first place.
Win, win, win, win.
(The real issue is that Robinhood forces market orders which make retail traders consumer of liquidity and makes all of this possible. But that’s a different issue and PFOF is not the bad guy.)
> The market maker (MM) pays 10c to Robinhood for the order, and buys the shares at 10c better @ 150.10. The MM has paid 150.20 effectively (151.10 + 0.10) when the next best buyer in the market was 150.00.
Is this possible due to the technicalities in regulations? Since they're paying a better price, it's OK that they purchase the order from Robinhood and fill it themself? The order didn't hit the "open market" or whatever we'd consider it. It was filled before then, but the best price on the open market was less than what was filled for, regulators are happy.
Very interesting that the money is from retail customers selling at bid, and makes sense.
If you'd like to share -- what's front running in this scenario and how would MMs front run this, assuming it's legal.
Sort of. It’s because the MM know that it’s retail order flow. Let’s say we forced all the volume to a lit exchange. The MM might not be willing to pay 10c (the fact that they don’t proves this) because when a fund comes in to sell, it won’t be just 100 shares. It will be 1mm shares, and so MM don’t want to quote sharp prices and then get run over with a huge order.
People think it’s MM ripping off retail. It’s not. It’s MM giving better prices to retail and ripping off professional traders.
because there's a lower risk of being run over.
https://www.bloomberg.com/opinion/articles/2021-02-05/robinh...
The relevant 3 paragraphs start at "If the retail trades are random..."
https://www.bloomberg.com/opinion/articles/2021-08-30/esg-ac... (Control-F “gamification”)
https://www.sec.gov/news/press-release/2021-167 (SEC Requests Information and Comment on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology)
https://www.sec.gov/rules/other/2021/34-92766.pdf
It’s really no different then incentives and financial mechanisms casinos use to get folks in the door. Or, as the saying goes, “if you don’t know who is the sucker at the poker table, it’s you.”
Whether or not Robinhood gamifies trading, or encourages gambling, has absolutely nothing to do with PFOF.
Ultimately people should be able to do with their money as they please, include gambling it away on risky options trades. Bad trading is naturally self correcting.
Robinhood is getting paid to bring a product (the user) to market makers. If you’re not paying for the product you’re the product, all the jazz.
> Ultimately people should be able to do with their money as they please, include gambling it away on risky options trades. Bad trading is naturally self correcting.
Agree to disagree. We regulate smoking, alcohol, pharmaceuticals, gambling, and other behaviors that have self harm. This is no different.
If you’re arguing that there’s a conflict of interest between Robinhood and its customers, then sure. But that’s got nothing to do with PFOF.
> Agree to disagree. We regulate smoking, alcohol, pharmaceuticals, gambling, and other behaviors that have self harm. This is no different.
Sure, I never said no regulation. You gotta stop with the strawman attacks. We regulate these industries, as we ought to do with finance, but we nonetheless allow people to drink/smoke themselves to death or gamble themselves into oblivion.
I’d rather live in a society where a small number people do enormous bad to themselves, over one where the state makes decisions for everyone.
PFOF does offer price improvement, which can effectively decrease the spread *for a particular marketable order". However, PFOF drives volume away from the limit markets, which determine the actual spread by which price improvement is measured against. So, it's a bit of a shell game.
Concretely, at least 20% of all stock market volume is internalized in PFOF-style firms (citadel, virtu, et. al). If that volume were all on the lit exchanges instead, the spread on those exchanges would be narrower on average.
> PFOF does not tighten "lit" spreads.
But that's fine right? This whole debate is about whether retail traders are being benefiting or losing (on net) from this. For the retail trader, the price improvement they get via PFOF is probably much better than the slightly better spreads they'll get on lit exchanges if PFOF was banned.
PFOF price improvement might be hundredths of a cent (per-share) off of a 3-cent lit spread. But, if PFOF were banned and all that volume were lit instead, the lit spread might actually be 2 cents, so you'd be saving $0.005 in this universe compared to the one we live in.
1. considering that retail volume dwarfs institutional volume[1]. Therefore I find it unlikely that there will be that much price improvement on lit exchanges.
2. part of the payment for order flow goes towards making trading free for retail traders. Even if I'm getting $0.005 better prices, that would be eaten up by the $5-$10 trade commissions I'd have to pay.
[1] https://markets.businessinsider.com/news/stocks/retail-inves...
No, because as other comments have mentioned, retail orders are generally "non-toxic" and "uninformed", which allows market makers to quote tighter spreads while still maintaining profit.
Institutional traders are the ones hurt by all of this. HFT latency arbing every single sniff you put out, front running every fill. PFOF has removed the uninformed order flow for hedge funds to trade against so they’re left trading against each other, or getting their lunch eaten by the aforementioned HFT.
That said, I hate how much volume is handled off book with these pricing approaches so not a huge fan of it?
What do you mean?
Some of the orders can be internalized. Not sure how often this occurs:
"The practice of internalization is prevalent in the Nasdaq market where Nasdaq market makers, who often pay for order flow or are sent order flow by an affiliate, trade proprietarily against incoming customer orders. NASD rules do not require Nasdaq dealers to expose their internalized orders to competitors."
On the markets - since so much retail volume is off the market, yes, the market maker has to price improve, but it's against a less than full picture of the market for thinly traded items.
“Off book” has a different meaning, which is why I asked.