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Let’s talk a little about retail brokers receiving payment for order flow (PFOF), in light of all the major online retail brokers now moving to a zero commission model. Indulge me please in this thread… #PFOF #MarketStructure
Sometimes industry jargon mask simple and logical truths. If a broker is SELLING your order to a market maker (MM), whether old school or high-speed evolved, that MM is buying it cuz they're making money by doing so. By subsecond quote arbitrage, and data collection. It is a vig.
It was pioneered by… Bernie Madoff in the 90s. At Instinet, sometimes employees managed or worked client orders. Our management encouraged us to whenever possible, route to MADF instead of “dotting” or using a floor broker. Get paid instead of pay…
Spreads then were wider… 1/8s and 1/4s. The MADF quote would be good for a 1000 shares typically. There was no price improvement. Routing to MADF gave MADF a short term free option.
They could choose to fill, or not. Sometimes the quote on NYSE they matched was lifted in process. Perhaps by MADF. No Bueno.
Fast forward to the 21st century. Stocks changed to trading in decimals. This drastically shrunk spreads. Stocks trading on different ECNs and exchanges – at various speeds – also created micro-arbitrage short term opportunities
and a new class of trader with SOES roots evolved to take advantage of those arbitrages. This also shrunk spreads. All good. Faster markets, requiring more knowledge of physics, and exchange created order types and nuance to help the arbitrageurs… meant one had to evolve
Initially, some market makers felt that PFOF was damaging to markets. Here is a 2004 Citadel SEC Comment letter stating this view: sec.gov/rules/concept/…
But then it all changed. Citadel today is probably the largest buyer of retail orders.
By the way, here is a little reading on what happens to retail orders: blog.themistrading.com/wp-content/upl…
Today, is PFOF good or bad? In benign low-vix market environments, in low spread stocks, it’s probably a wash for retail market orders.
The fill retail gets is roughly equivalent to what they would get if their broker routed it to an exchange. However, in volatile markets… not so fast! See the SEC 2010 Flash Crash report.
Also, when high speed market makers buy all these retail orders – they do so knowing those orders are “the dumb money”. They would not pay to get a Stevie Cohen order that will run them over…
And they model this data. And use it to help ascertain market direction for which they can trade. I think?
There is an often not discussed problem. The public exchange limit book. Why would one bid 50 cents for a stock, create the new best bid, only to be rewarded with NO FILL and Opportunity cost?
You see, the MM intercepts the sell order that would have rewarded you with a fill. Because they paid for that right. Ugh.
So the public exchange order books have very poor incentives for diversity. INVESTORS are disincentivized due to PFOF. And the orders that do make it to the exchange are “tagged”. “Look at me!” Fun.
Even more fun for institutional investors… because their orders are not tagged on the exchange. The stand out now. IF the BOOK has high speed flickerers, and retail that is tagged, then its easy to point to whose left and guess that those orders are bigger and have information
So… PFOF is weird. It may provide some benign price improvement that’s economically de minimis for mom and pop on a calm day, hose them in volatile markets, yet it creates bad incentives for being represented as an investor on public order books/exchanges.
Which also makes markets worse in times of stress. Do you really want a public limit order book – exchange, where in fast times and markets under stress… the book is only populated by a handful of high speed traders? Diversity is a good thing in markets.
Today… it seems we the SEC has thrown in the towel on this issue. The practice has been allowed to exponentially proliferate, and I worry one day we will rue the day….
The ONLINE BROKERS going to $0 commission and selling all order flow is such a conflict of interest, and we accept it. Ok. Maybe I am old.

Phew. Coffee.....
I am adding to the thread. I want it to be more balanced, so that a reader can make up their mind. I have a good friend "on the other side" - and I want to add some of their thoughts... which do have merit as well.

So here goes... what follows is roughly" in quotes :
- open an online acct. Trade for free. and the price you'll get on any order up to 9,999 shares will be better than you can get through nearly anywhere...

there is well in excess of a$1billion prioce improvement off NBBO given...
high speed market makers take billions in risk to provide that price improvement... and get run over plenty too.

on average does that business make money? of course it does. But they pay back far more in price improvement than they make...
there's zero ability for any of that to happen on an exchange

that's why the wholesaling business is here to stay

rant over."

So - the other side as well...
There definitely are multiple ways to look at it. I dont have all the answers. Just an opinion. I can be open-minded to this as well.
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