- Payment for order flow, where Wall Street dealers pay retail brokers for retail investors’ orders, has captured the attention of the trading public.
- Wholesale dealers fill retail orders at an outsider’s price then pay an insider’s price themselves, capturing the difference.
- Retail investors need their own insider – a broker-dealer with access to insider prices that works for them.
- This article describes a hypothetical retail investor’s trading system that gives retail investors direct access to insider prices.
- A daily audit trail would permit retail investors to see improved results.
What retail brokers lose by charging no brokerage, they recover by getting paid for retail orders by wholesale broker-dealers – called payment for order flow. The wholesalers fill retail orders at an outsider’s price then pay an insider’s price themselves.
In the language of the Street, wholesalers pay brokers to “scalp” the brokers’ retail orders.
A new hypothetical transaction system turns the tables on the Street – retail traders do the scalping. The system puts retail in control and simultaneously “opens the brokers’ books,” giving retail customers all the information they need to choose between transaction systems.
How retail confronts the Street
This transaction system interacts with other participants in the national market system (NMS) through a captive broker-dealer. The retail broker-dealer trades with Wall Street on behalf of the entire retail investor population it serves. It acquires securities from other broker-dealers and exchanges within the NMS, then passes the results to retail investors. This process assures that retail investors receive a wholesale inside price.
In other words, the scalper works for the retail investor, not against her. This new kind of retail-controlled broker-dealer would seek to scalp the Street.
An open broker’s book
Investors don’t want the appearance of low costs. They want certainty and transparency. An audit trail can provide that. Any audit trail today is complicated by the absence of a vendor that provides retail brokers with a single daily record of the costs of all its financial services.
A daily audit trail is a key to broker transparency. A retail broker using this system could provide a daily report of your income, capital gains, and costs by line item and the value of your account to your broker.
For the first time, investors would have a yardstick to compare the cost and quality of the new transaction system to any other transaction system effortlessly.
A retail trading system that provides the entire range of investment services with a comprehensive day-to-day audit trail does not exist today. There is no excuse for that. If one system provides a daily audit trail, others will be forced to follow suit to survive competition for retail business.
This transaction system is an antidote for NMS complexity.
Complications within the NMS that retail’s captive scalper would exploit
The main reason broker-dealers can beat the prices they provide to retail is the absurdly complicated NMS. The details of the NMS system described below have no earthly purpose. Moreover, they make the pricing process opaque to outsiders. Many of the activities we call innovations in securities trading today are unnecessary costly adaptations to the NMS rules. There are many firms that exist only to exploit poorly framed NMS rules.
“Part of” the system or “because of” the system? Firms that would not exist if there were no NMS.
Multiple exchanges. At last count, there were 17 SEC-approved stock exchanges inside the NMS, and many more alternative transaction platforms, all sources of execution and potential arbitrage for electronic high-frequency traders. Many of these transaction platforms suggest that they save one or another investor class money or offer better execution to that limited class.
At least 14 of the 17 existing exchanges depend on the NMS rules for their existence. How many simultaneous quotes of the same bid and ask prices does the market benefit from seeing? It stretches credulity to argue that the answer is anything more than three. The other exchanges thrive on their SEC subsidies and fees they charge brokers at inflated SEC-protected levels.
Yet broker-dealers feel constrained by reputational concerns to pay for an active computer presence on all exchanges. This competitive pressure to match other broker-dealers’ exchange presence allows the exchanges to charge high fees without attracting a substantial market share.
The new exchange, MEMX, depends for its existence on the excessive fees charged by other exchanges and its promise to charge less.
Costly speed merchants. The high-frequency trading firms. By encouraging the multiplication of exchanges across the landscape, the NMS has inspired a class of broker-dealers, known as high-frequency traders, to pay each exchange a fee to colocate a computer at the site of each exchange transaction engine. Algorithms that seek to profit from disparities between prices among the exchanges drive these computers to generate 70% of total exchange transactions today.
In addition, the new exchange, IEX, depends for its existence on the need of some institutional traders to foil high-frequency traders.
Wholesalers. The regulation-created, excessive-fee-charging, multi-exchange securities exchange firms have become so top-heavy that OTC firms like VIRTU and Citadel are more efficient transaction engines than the exchanges.
The result has been payments for order flow. Without the NMS-created inefficiencies of the multi-exchange securities market, the wholesalers and payments for order flow would disappear in an instant.
The OTC markets that wholesalers provide are innately inferior to exchanges in the function of transaction matching since the firm-to-firm bilateral OTC model creates principal credit risk that an agency exchange does not. However, the exchange system is so inefficient that its costs cancel its innate advantage, providing an opening to OTC wholesalers.
Payment for order flow
The primary unnecessary NMS expense identified by a recent Wall Street Journal article and a speech by the new SEC chair is payment for order flow. Yet neither the Journal article nor Chairman Gensler gives us much detail – concrete steps the SEC will take to improve financial market efficiency – other than to suggest eliminating payment for order flow, currently the whipping boy of Wall Street.
Moreover, within the existing incomprehensibly byzantine inefficient SEC-regulated NMS that services retail traders, payment for order flow reduces transaction costs.
Furthermore, wholesaler firm Citadel’s CEO Kenneth Griffin coyly suggests that he would be “fine” without payment for order flow as long as the standard of best execution remains in place.
In other words, Griffin believes that wholesalers, or at least Citadel, can make more money from quoting outsider prices to the retail brokers than from paying fees to them for the privilege. Citadel understands that it is not paying fees to brokers that butter Citadel’s bread, its access to retail customers’ relatively poorly informed orders.
But Griffin, like most of Wall Street, takes the NMS complexities for granted. He asks how his firm can provide a valuable service at a profit within it. How can the SEC find fault with that? The function of broker-dealers like Griffin’s Citadel is to maximize profits within the NMS.
Physician, heal thyself. However, the function of the SEC is to create conditions where broker-dealers do not waste retail customer money. If the SEC made a few modifications to the NMS, many of the existing firms and much of the unnecessary cost of retail services would vanish.
Evidence abounds that the SEC is not going to act. Responsible business plans take the status quo within the NMS to remain unchanged.
How to identify new financial services with retail customer value
The essential distinction between constructive improvements and unnecessary added costs found its way into the Journal article cited above, in the form of a remark by Chris Iacovella.
“You’ve got some big actors here whose entire business model in the equity market space is based on current [NMS] rules. They’re going to do everything they can to not have to change their business model.”
The way forward for retail investors
Any transaction system that permits retail traders to avoid paying these NMS-inspired costs will have an edge in comparison to its competition. To provide a consistent efficient trading system it is necessary to “distance” system participants from the NMS.
Instead of waiting for the SEC to get its act together, retail investors should be proactive. The key is to innovate in a way that works whether the SEC reforms the NMS or not.
To be a permanent innovation in the trading space, not an exploiter of NMS, an innovation must be available and valuable if the NMS is unchanged, but more importantly, it must still be useful when the NMS removes its subsidies of pointless exchanges.
There are at least three candidate innovations that meet these two criteria.
- Reverse the scalping of retail investors.
- Simultaneous transactions and clearing.
- The malleability of listed instruments. Exchange-created instruments that improve the bottom line of investors, that better meet user objectives.
The structure of the linkage of the hypothetical retail system to the greater NMS is displayed graphically below. The retail system trades and inventories cash balances and retail system-created securities. The clearinghouse transfers margin funds from long to short. It also transfers securities and securities payments from the captive broker-dealer to the buyer. The exchange management fund inventories NMS securities backing retail system securities and trades these securities on the buyer’s behalf.
One key to the success of the retail system is that it presents a single portal to the NMS. Securities enter and exit the system at prices attractive to retail investors as a group. The retail system has access to insider NMS prices through its captive wholesaler.
Other new retail transaction system capabilities
Simultaneous trading and clearing. This retail transaction system clears retail system securities when they are traded. The existing NMS cannot.
The rights of corporate ownership of NMS securities are transferred to the captive broker-dealer making simultaneous trading and clearing feasible. Transfer of ownership is time-consuming and expensive on one hand, and not of interest to most investors on the other. The rights to income from the securities belong to the buyer. Buyers then escape the costs of ownership transfer. Retail trading system clearing is described in greater detail here.
Creation of retail-friendly securities. The retail system can design new securities backed by the existing NMS securities that better meet investor needs. The most obvious missing investment in the current securities space is a liquid private term debt instrument with homogeneous maturities (1 month, 3 months, 1 year, 5 years…). The creation of retail-friendly trading instruments is detailed here.
Retail needs a hired gun – a retail system broker-dealer that trades with the Street on behalf of retail traders but is incentivized to beat the Street.
The change in leadership at the SEC gives the markets reason to consider the state of our market structure since Chairman Gensler has informed us that this will be his primary focus.
Retail traders and investors are ill-served by the status quo NMS. Moreover, the purpose of the NMS, access for all to market-wide securities prices, can be better achieved in the case of retail investors by the hypothetical retail system described here.
The key contributions of the system.
- An end to retail investor scalping. A retail transaction system broker-dealer that acts on behalf of retail investors.
- Full system accountability to retail investors. Simplified trading that enables provision to investors of a daily system-wide audit trail.
- New securities that better meet investor needs such as liquid term debt instruments.
- Instantaneous costless clearing. Reduced trading costs.
This post from Kurt Dew