flipping channels tonight and i came across the all storage wars station. For those of you that haven’t watched cables worst television show, it centers around a group of niche market experts bidding on storage lockers whose owners are in default. A locker with art invariably captures the interest of the shows art expert, a locker with furniture likewise results in more aggressive bidding from those with knowledge of that market. While completely unwatchable, the show does offer up an important lesson on markets….having a selection of participants with varying areas of knowledge will result in greater competition for the quote, and a more aggressive market. If instead of having multiple bidders, the storage lockers asked a single liquidator to bid on all lockers in default they would likely end up with a worse result. This is why you never sell your house to the first person to view it before other potential buyers have had a chance to look and prepare a bid.
So why then do intelligent, well informed retail brokers make bilateral deals with wholesalers to route their flow in aggregate rather than route each order based on the best likely outcome for that particular order? The answer is of course, that dealers are being paid a kickback – euphamistically referred to as payment for order flow – to route in this manner. The dealers are doing what is best for them, not their clients. This mistreatment of clients is then justified by 605 and 606 reports showing that retail clients achieve price improvement, and perhaps size improvement, over the visible quote some 90 percent of the time. This is what i call obfuscation through transparency. The stats provided are real, but fail to consider what would have happened had the order not been sold months or years in advance of it being entered. The order may well have received far greater size and / or price improvement had it been routed to a venue like Posit, IEX or even the Bats midpoint. You have to give the retail dealers credit for using reports required by the regulators to justify an unjustifiable act.
Now the defenders of the practice – i.e. Citadel, ATD, Ameritrade and pre 2012 Chris Nagy – will argue that retail clients have never been better served. They receive certainty of fill versus a tighter than ever spread and pay ridiculously low comission rates. This may well be true, but that doesn’t justify the act. The ends do not in fact justify the means. See by not allowing the market to compete for the quote on these retail trades, the discount firms are lining their own pockets at the expense of the very institutional firms that make price discovery happen.
Much like storage wars, price discovery in equity markets is dependant on a variety of players bringing their expertise to bear to value the corparate issues at play. Top down guys, bottom up gals, strat arb players valuing versus other assets all add to the price discovery in the market. Together they create a quote that is widely believed to be a reasonably fair valuation of the shares given the state of known information in the market. Without a quote that retail players have confidence in, they are highly unlikely to trade. The majority of retail investors lack the ability and quick access to data to reasonably value the shares they invest in. Instead they assume the current market is near fair and then bet on a given name either out performing or under performing the market based on their knowledge of product, sector, management or love of the brands current advertising. They effectively borrow fair valuation from the aggregate of institutional flow, and in a fair market would reward those players setting price by placing orders in a manner that these same players could compete for the order. Instead the institutions setting price are displaced by kickback paying wholesalers who profitably gain access to the flow via payment for order flow. The retail dealers win with lowered costs, the retail client is told they win with price improvement and low commissions, the wholesalers only pay the kickbacks because it is highly profitable, so who is paying for this operation? The institutions. They lack access to unmolested retail flow, and have lessor ability to passively achieve liquidity in their chosen trades.
PFOF is nothing but a wealth transfer from institutional investors to wholesalers and retail dealers. When you consider the significant intellectually effort that is not being properly rewarded because of this process you can begin to understand why institutions are frustrated by the state of secondary equity markets. markets should allow for investors to compete on a fair basis. Allowing wholesalers to bypass competition via a payback to the agent is anethema to the fundamental nature of efficient markets.
currently the SEC is considering 605 and 606 type reports for institutional orderds. instead they should ban the act of buying first access to flow. Any report that is commonly used to justify kickbacks to agents is a report that should be banished, not a report that should be replicated.
by hey what do i know, i just trade for a living.