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Payment for order flow - backdoor kickbacks


LongHaul
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This article is hard to understand. For the payment of order flow example, if a broker asks for premium payment of order flow, why would the exchange just give it to them? I am a bit confused here.

 

Where there is mystery, there is margin.  Hard to fully understand for me also.

 

I believe the exchange then sells the info to high frequency traders who front run the orders. Clearly the HFT must be making money off paying for the PFOR or they wouldn't buy it. 

 

Interactive brokers doesn't do this (or minimally).   

 

I would imagine that fees are quite a bit higher if one includes the losses from PFOF in the other discount brokers total fees.

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This article is hard to understand. For the payment of order flow example, if a broker asks for premium payment of order flow, why would the exchange just give it to them? I am a bit confused here.

 

I think the HFT are the true customers of the exchanges. That may be all one needs to know.

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I'm not quite sure if that articles uses the right terminology to describe what happens.

 

As far as I understand, and of course I could be wrong, brokers sell their order flow to HFT firms, not to exchanges. The HFT firms look at the orders, and execute those orders that they think have zero/negative alpha (for example: market orders from retail investors). Retail investors gain a little bit here as well since the HFT firm has to provide a better price than the NBBO to make this happen (although it's usually a very pathetic $0,0001/share or something like that). Orders that the HFT firm then doesn't want to execute are routed to the various exchanges and executed at the NBBO (if marketable). The big downside of this scheme is that the remaining order flow that is hitting exchanges is more toxic (from the point of view from a market maker) and as a result spreads might go up, and so in the end even the retail investor that is getting a price improvement from the HFT firm might actually be paying more.

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This article is hard to understand. For the payment of order flow example, if a broker asks for premium payment of order flow, why would the exchange just give it to them? I am a bit confused here.

 

Where there is mystery, there is margin.  Hard to fully understand for me also.

 

I believe the exchange then sells the info to high frequency traders who front run the orders. Clearly the HFT must be making money off paying for the PFOR or they wouldn't buy it. 

 

Interactive brokers doesn't do this (or minimally).   

 

I would imagine that fees are quite a bit higher if one includes the losses from PFOF in the other discount brokers total fees.

 

So is there an advantage for us to trade in IB vs other retailer brokers? Unless your order is so large to tip off HFT to front run you, I'd think there is no difference trading in IB vs other retail brokers. Am i right?

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  • 1 year later...

your order doesn't  have to be large to tip off HFT. I really ticks me off - even as a retail investor making a trade for say $20K, I am always front run and my order is $0.01/share higher then the last trade. I guess my broker is complying with the "best effort" rule, but it still stinks.

 

LL

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From the 2018 IBKR annual.  I really like Mr. Peterffy - one of a kind in the financial industry. 

One of the problems with PFOF is that the whole thing is not transparent to the retail customers.  Where there is mystery, there is margin. 

I thought the other article posted a few posts before likely left out some big things.

 

Dear Shareholders:

Since we started our business 42 years ago, we have focused on automation to

be able to provide superior services at lower cost and better execution prices than

our competitors.

This has served us well, as our 2018 results reflect. We hit new highs in client accounts,

client equity and earnings in our brokerage business. While we are pleased with our

success, we are concerned about an ongoing trend that will damage the U.S. equity

markets if it continues.

Over the past two decades, high frequency trading and the buying of retail orders by

HFTs have become ever more prevalent phenomena in our markets.

HFTs buy the retail orders and fill them internally by taking the other side of these orders. As a result, we see fewer and

fewer retail orders come to the exchanges to trade with displayed limit orders. These limit orders end up trading with other

institutional orders and with HFTs when they need to pass out of imbalanced positions they accumulated on one side of

the market.

Trading against HFTs and institutions taking liquidity is generally not profitable, at least in the short run. As a consequence,

market participants are reluctant to place limit orders and the NBBO (the National Best Bid or Offer, or the highest limit

order to buy and the lowest limit order to sell) becomes wider.

HFTs are obligated to fill the orders they buy inside the NBBO to the extent of the size displayed. The wider the NBBO

becomes, the more discretion an HFT has as to the price at which it fills the order and, therefore, the more profit it makes

and the more it can then afford to pay for these orders.

The more HFTs pay for retail orders, the more brokers will sell their orders to HFTs and, consequently, even fewer orders

will trade at the exchanges in a competitive market. Also, the more payment the brokers receive for their customers' orders,

the more they can discount the commissions they charge their customers. Hence the newly emerging zero commission

brokers. However, the customer is likely to lose more on the execution price than she saves on the commission.

This is a self-reinforcing feedback loop in which wider markets cause even wider markets, increasing payment for orders,

moving more volume off the exchanges. Indeed, while in 2008 26.6% of the listed stock volume traded off the exchanges,

by 2018 36.3% of the volume traded off exchange.

What is the predictable consequence?

Liquidity vanishes.

Momentum traders drive the markets to more extreme highs and extreme lows in shorter periods of time.

Investors holding margin accounts become less able to liquidate, adding to the price swings.

This is a disaster waiting to happen.

While all of us in the trading and investment community have in one way or another adapted, and would prefer to let things

continue along the status quo, we cannot pretend that all is well the way it is.

We must implement structural changes to the markets before it is too late.

In this vein, we will draw our customers’ attention to our newly introduced “Midprice Orders” that attempt to fill orders in the

middle of the NBBO. More volume trading at the midpoint will attract more midpoint orders, thereby reducing the viability of

the payment-for-order-flow model and counteracting the vicious spiral to disaster that I describe above.

With your participation, we are looking forward to a rewarding year.

Sincerely,

Thomas Peterffy

Founder and CEO

February 25, 2019

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Thanks for the post Longhaul.  I can't agree more that the decline of meaningful limit orders is to the detriment of us all.  Of course, when I place a limit order for 500 shares on a 23 bid, only to see it filled by a HFT at 23.0001, it just makes me pull my offer and use more judicous market orders instead.  Until 5 years ago, I never used market orders but now they are the only way to get a fill between the bid/ask as placing a limit order between the spread just moves the HFT's bid/ask for most of the stocks I like (If only I stuck with FANG stocks, high frequency trading would be my friend).  On the plus side, the trend to zero commission rates, lets me break my trades into smaller pieces, and best of all free commissions means someone can't screw me over by selling me a single share on a limit trade and sticking me with the commission charge and try to nudge me off the NBBO.

 

Of course, there is no "free" in free commissions, now I have to spend my time moving available cash around to avoid leaving cash in crappy sweep vehicles (I'm looking at you TDA!).  Fidelity seems to treat me best there, but they don't let me buy low priced stocks even if the low priced stock has a share price over $1000, but that's another rant. I'm starting to getting worked up so time for me to take a chill pill...

 

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Thanks for the post Longhaul.  I can't agree more that the decline of meaningful limit orders is to the detriment of us all.  Of course, when I place a limit order for 500 shares on a 23 bid, only to see it filled by a HFT at 23.0001, it just makes me pull my offer and use more judicous market orders instead.  Until 5 years ago, I never used market orders but now they are the only way to get a fill between the bid/ask as placing a limit order between the spread just moves the HFT's bid/ask for most of the stocks I like (If only I stuck with FANG stocks, high frequency trading would be my friend).  On the plus side, the trend to zero commission rates, lets me break my trades into smaller pieces, and best of all free commissions means someone can't screw me over by selling me a single share on a limit trade and sticking me with the commission charge and try to nudge me off the NBBO.

 

Of course, there is no "free" in free commissions, now I have to spend my time moving available cash around to avoid leaving cash in crappy sweep vehicles (I'm looking at you TDA!).  Fidelity seems to treat me best there, but they don't let me buy low priced stocks even if the low priced stock has a share price over $1000, but that's another rant. I'm starting to getting worked up so time for me to take a chill pill...

 

Just break your order in small little limit orders at slightly price points. That’s what I am doing, especially now with zero commission trades. FWIW, I don’t think Fidelity gets paid for order flows and In did an analysis for myself that the commission savings far outweighs the rebates I am getting (price improvement). That’s for small order of maybe 50-300 shares or so, which I how I like to go about this now. if you do orders > 1000 shares, then the rebates become more noticeable.

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Fidelity seems to be the only broker that does not get paid on order flow AND also charges zero commissions AND gives a very good interest rate on cash if you select their government obligations sweep fund. How does it make money then? ::)

 

Advisor fees, if you pick their advisory services. It’s hard not to recommend Fidelity and if you don’t want to dive into foreign stock markets, I would argue it’s better than Interactive Brokers.

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