By Jeff Bacidore, Founder and President, The Bacidore Group LLC
As with Gamestop, I hesitated to write a payment for order flow post given that so much has been written about this already. But since it is a topic that comes up often, I thought I would share my take. To me, there are two key issues. First, when a broker receives a payment, where does that payment go? And second, with so much volume being diverted off the exchanges, is market quality (e.g., the NBBO) negatively impacted by payment for order flow arrangements. The former is about whether the benefits of payment for order flow ultimately accrue to retail traders or to their intermediaries. The latter question is about how all end investors – retail, institutional, etc. – are impacted by payment for order flow, or more generally, by the diversion of retail orders off-exchange.
The first question – where does the payment go? – is an essential question for retail investors. In an idealized world of pure competition, the entire payment would flow back to the retail investor, as wholesalers competed down to their marginal cost (a la Econ 101). Effectively, the retail trader would get a net price equal to that which they would in the absence of payments. But this assumes that the wholesaling is a “purely competitive” business, and not a virtual oligopoly as it is now. It also assumes that retail brokers not only have the incentive to return payments to investors (directy or indirectly), but also the ability to do so. For several years now, the argument put forth was that payment for order flow was returned to investors in the form of lower commissions. Back in the dot com days, people would say that this is what made electronic brokerage competitive – you can’t have $9.99 trades without it. But flash forward to 2021, where we now exist in a zero commission world. Now, one wonders, how exactly a broker could return payments that exceed the cost of providing broker services.
For example, if it costs only $1 for a retail broker to execute a trade, but they get back $1.50 in payments, where does the extra $0.50 go? Maybe it subsidizes margin or other parts of the business. Maybe it pays for the slick app, electronic confetti (kidding!), or some other service. But even then, what if the payments exceed even those costs? I think the parallels to Facebook are instructive. There, Facebook users are charged nothing to use the service, while Facebook receives payments from advertisers, which presumably offset the operating costs. What happens if the advertisers pay more than the operating cost? The fact that Facebook is approaching a market cap of $1 trillion dollars might provide a hint as to where excess payments tend to gravitate.
The second key question in the debate is what the effect on market quality is when so much flow – and a very specific kind of flow – is being diverted from the market. With regard to bid-ask spreads, the argument is that the lack of retail traders participating on-exchange results in a larger NBBO. Had the retail orders been routed to the exchanges, the argument goes, liquidity providers would be willing to quote more aggressively, as they are more likely to interact with an “uninformed” retail trader. How much tighter would the spread be? An interesting paper by BestEx Research suggests that spreads could be 25% lower than they currently are. But perhaps what’s even more perverse about this is that the wholesalers’ actions themselves actually help to increase both the volume they trade and the per-share profits that accrue to them.
The alternative would be letting other market participants interact with retail flow, making bids and offers become more competitive. And in fact, given that the exchanges offer programs aimed at benefiting retail traders specifically, the preferential treatment coupled with greater competition could yield a better trading experience to retail investors, especially if either the wholesale market is not purely competitive, as some would argue, or that retail brokers are unable to return the full benefits of payments back to investors. Can we get to that alternative market structure? Unfortunately, this is highly unlikely given the incentives to route away from the exchanges. And this is only exacerbated by the abnormally large spreads on liquid stocks caused by excessively large tick sizes.
But even in a world of wholesaling, one can’t help but wonder how retail brokers justify not even trying to get a better execution. Not only on an order-by-order basis, but as a matter of policy. For example, many institutional brokers and buyside traders will set up A/B trials or “horse races” to see whether routing policy A is better than routing policy B. But looking at routing tables from some retail brokers, one simply doesn’t see any evidence that they are even attempting to determine the best venue. The increased latency in fills would be de minimis and unnoticeable to most retail investors. Perhaps retail brokers can justify this one-size-fits-all-always routing behavior. I just haven’t seen any evidence (and as a retail trader myself, I believe the best I ever did was price improvement of a few mils per share on a $200+ ETF. Gee, thanks).
Before closing, I think it is important to point out one of the great ironies in all of this. The exchanges – or better put, the traders participating on these venues – set the NBBO, which is a critical input to the off-exchange trading model. The exchanges are required by regulation to share their best prices with wholesalers, who then siphon the very flow that would help make those prices more competitive. Institutional traders, passive retail, and other on-exchange traders who put their orders at risk and contribute to price discovery enable basically a handful of firms to trade more profitably by both providing critical pricing information as well as a destination for them to help manage their risk, e.g., by routing “exhaust” flow, and potentially trade profitably. It’s like your neighbor not only borrowing your lawnmower, but making you cut his grass for him as well.
 See “The Good, the Bad, and the Ugly of Payment for Order Flow”, by Hitesh Mittal and Katy Berkow of BestEx Research, May 2021.
Payment for Order Flow: My Two Cents (Per Hundred) first appeared on The Bacidore Group blog.