Thread by @dlauer

Ok, it’s time for some game theory. For real! Let’s talk about the conflicts-of-interest at the heart of nearly all equity routing today – rebates & payments. These inducements (that’s an important word) influence how brokers route orders, for retail and institutions.

First of all, for retail, I think everyone understands that PFOF involves market makers paying brokers to send retail orders to them. Most of the time these are marketable orders. Limit orders are often sent to exchanges.

For example, here is Fidelity’s order routing showing marketable orders going mostly to Citadel and Virtu, and non-marketable orders going to NYSE and Nasdaq. Non-marketable limit orders receive a rebate when they are sent to an exchange

Those rebates are between 18 - 30 mils on Fidelity's routing to NYSE and Nasdaq (1 mil is $0.0001, so that's $0.18 - $0.30 per hundred shares).

Institutional orders OTOH mostly execute in broker-owned dark pools or on exchanges. These too are often induced to go to the lowest-cost venue – executing in a broker’s dark pool that is routing your order means the broker doesn’t have to pay any fees.

Executing limit orders on an exchange often means the broker collects the rebates (cost-plus routing is an option, but isn’t as common as it should be).

So that brings us to MEMX. MEMX is a relatively new stock exchange, partially owned/funded by Citadel, Virtu, a couple of retail brokers and other financial firms. Their market share has been climbing throughout the year (recently crossing 4%), although only on a per-share basis

By total dollar volume they are still under 1%. MEMX is a preferred destination for trading low-priced stocks in large quantities. Is this because of superior execution quality? Or is it because they pay the highest rebates of all exchanges, topping out at 31 - 37 mils?

But wait Dave – aren’t access fees capped at 30 mils by Reg NMS? How can they possibly pay such high rebates??

Yes they are, and I’m impressed with your market structure knowledge. That fee cap means that no exchange can charge more than a 30 mil fee.

So that means that MEMX is operating at a loss on those trades. How can they do this? Well they’ve got funding – they’ve raised $135M! So they can keep operating at a loss, and attracting order flow by paying the biggest kickbacks to brokers.

I’m talking about this for two reasons. First, it’s easy to focus on PFOF when we should really be concerned with all order routing inducements. Exchanges paying rebates is almost as bad as wholesalers and PFOF.

Second, it’s also easy to forget that we, the public, are subsidizing all of these exchanges, especially the ones that pay inducements. Paying these kickbacks results in more orders resting on the exchange, which nets them more of the SIP money that the public pays.

SIP fees are charged for every investor who sees a quote on their broker's platform (and other places), and amount to over $300M that are given to exchanges, which is economic subsidization that keeps exchanges profitable even when their execution quality is shitty.

Instead of an overly fragmented market subsidized by the public & inducing orders to be routing for kickbacks, we should aim to create a simplified market structure without subsidization or kickbacks, where orders are routed for the best possible execution quality.

End Rant.

I realize I forgot to tie this back to my first tweet's mention of game theory. This entire structure is a prisoner's dilemma that has led to a race to the bottom. When exchanges do the right thing by not paying rebates, they don't get market share. That's wrong & bad for mkts.