FLASH FRIDAY: PFOF Under the Microscope (Again)

FLASH FRIDAY is a weekly content series looking at the past, present and future of capital markets trading and technology. FLASH FRIDAY is sponsored by Instineta Nomura Company.

This week’s highly publicized GameStop hearings on Capitol Hill have put payment for order flow under the microscope, yet again.

The backstory, in a nutshell: GameStop stock surged eightfold in a week in late January, only to drop almost 90% in the subsequent two weeks. The extreme gyrations were driven largely by a retail buying (and selling) frenzy, with orders pushed through Robinhood and other platforms that cater to retail investor. 

But as it turns out, Robinhood makes its money not by trading commissions (which are zero), but by selling its order flow to large institutional market makers. 

So the question is, does Robinhood do right by its end-user investors, which as a fiduciary it is obligated to do? Or does the PFOF arrangement mean its paying customers first and end-user investors come second?

As legislators, brokerage CEOs, retail traders, and financial executives met on Thursday to discuss what happened, what conflicts of interest PFOF presents, and what (if any) remedies are needed, it’s worth noting that PFOF has been a lightning rod for controversy for many years. 

A May 2006 article in Traders Magazine, “A Whole New Ballgame”, was a snapshot of the PFOF state of play at the time: 

“ATD is one of a handful of wholesalers fighting over retail orders not destined for the nation’s primary stock exchanges.

Others are Knight Capital Group, Citadel Execution Services, Bernard L. Madoff Investment Securities, Citigroup, UBS Securities and E*Trade.

They all compete for the order flow of a few hundred larger self-clearing retail brokers and clearing houses…

After Knight’s broker-dealer division reported lousy results in the first quarter of 2005, Knight took action. It disbanded the entire unit and built a new one from scratch. Jim Smyth, a 24-year Merrill Lynch veteran, who was running soft dollars at Knight at the time, was asked to run the group.

As part of the revamp, Knight dramatically increased the amount of incoming flow it traded algorithmically. About 90 percent is now done with algos, according to chief executive Tom Joyce, an “eight fold increase” over levels of a year ago.

“In this day and age,” Joyce says, “computer-driven algorithmic trading protocols are the only way we can efficiently handle the order flow as well as provide the cutting edge stats our customers are demanding.”

Better Stats

The change improved Knight’s execution stats “almost immediately,” Joyce added. Order senders’ reports bear him out. Several sent Knight more flow in the fourth quarter than in past quarters.

On the Nasdaq side, Citigroup sent 24 percent of its Dash-6 reported flow; up from 5 percent a year earlier. Merrill Lynch sent 22 percent; up from 16 percent in the third quarter.

Southwest Securities sent 38 percent; up from 22 percent in the second quarter. ADP Clearing & Outsourcing sent virtually all of its orders; up from zero in the second quarter.

Similar gains were seen on the listed side, especially from ADP Clearing & Outsourcing, Raymond James and Piper Jaffray. Knight’s gains here came at the expense of the NYSE and Madoff.

Despite making changes to better accommodate order senders, Knight has also become more choosy about which orders to handle.

Both Knight and UBS, have actually segmented their client bases and are being less generous with their services. That’s especially the case when it comes to payment for order flow.

As part of last year’s re-organization, Knight took a hard look at the levels of service it was offering and decided to “rationalize” them, Joyce explained. Everything was open for review including payment for order flow and automatic execution levels.

Clients were divided into different groups. Those receiving payment for order flow were encouraged to participate in revenue-sharing agreements with Knight. Some agreed to; some did not.

Business Out the Door

Some of those that did not took their business elsewhere. Joyce won’t disclose any names. A glance at TD Ameritrade’s Dash-6 report, however, shows significant drops in the amount of listed and Nasdaq flow sent to Knight.

(TD Ameritrade’s Nagy maintains receiving payment for order flow is consistent with a broker’s best execution obligation.)”

Knight took sterner steps with some of its other customers. For those whose order flow it deemed hazardous to its health it eliminated the PFOF rebate altogether. In some cases, it began charging for their orders.

With the re-org and the cutbacks in payment for order flow, Knight saw a sharp drop in the number of Nasdaq shares it traded. In January 2005, Knight traded, on average, 310 million Nasdaq shares per day.

By October, that figure hit 196 million. This February, it rebounded to 233 million. Listed volume was not much affected. Those figures include trades done on behalf of money managers as well as broker-dealers.

“Certainly, the change in our offering drove a lot of that order flow away,” Joyce says. “But that was order flow we didn’t really want. We view the changes as a success.”

Success for Knight now means profitability, execs there say, not market share rankings. That speaks volumes about just how much the wholesaling business has changed.

Knight was once the dominant wholesaler of Nasdaq and listed securities. Now UBS is the largest trading house on Wall Street. The more automated players are clearly in the vanguard.

“I guess it is no surprise that more and more firms are looking more like ATD today,” Swanson says. “If a firm does not have a nearly automated model, they will find it a very difficult business.”

Fast forward 15 years, payment for order flow is still with us, and it is still controversial. And while the GameStop brouhaha may result in a regulatory tweaks, but in another 15 years, PFOF most likely will still be with us.