Friday, February 5, 2021

Money Stuff: People Are Worried About Payment for Order Flow - btbirkett@gmail.com - Gmail

Money Stuff: People Are Worried About Payment for Order Flow - btbirkett@gmail.com - Gmail

Money Stuff: People Are Worried About Payment for Order Flow

 

Banning PFOF or whatever

Okay let’s do payment for order flow again, because people are talking about it and that always stresses me out. Here’s an intuitive description of how it works.[1] A million people come to a broker to trade GameStop Corp. stock. Half of them want to buy shares, half of them want to sell shares. One share each, all using market orders, all at precisely the same time. The stock exchange has half a million shares of GameStop available for sale at $58.25, and orders to buy half a million shares for $58. The broker could send all of its customers’ orders to the stock exchange, where the buy orders would be filled at $58.25 and the sell orders would be filled at $58; the broker would pay the exchange a small fee for executing these orders.[2]

 

But! The broker realizes, look, all these people who want to buy shares could be matched up with all these people who want to sell shares. I don’t have to pay a fee to the exchange, the buyers don’t have to pay $58.25, and the sellers don’t have to get $58. The buyers could pay $58.15 and save 10 cents, the sellers could get $58.10 and make an extra 10 cents, and I could keep 5 cents (and avoid the exchange’s fee) for my trouble. That’s a good deal for everyone!

 

This is called “internalizing”: Your broker executes your order internally, against its other orders, rather than sending it out to the exchange. In practice a typical retail broker doesn’t have the ability to do this, so it sends its orders to what is usually, in the business, called a “wholesaler” (or sometimes “internalizer”), and usually, outside of the business, called a “high-frequency trader.”[3] Popular wholesalers include Citadel Securities, G1X Execution Services LLC, Two Sigma Securities LLC, Virtu Financial Inc., Wolverine Securities, etc. The wholesaler does the thing I just said: It pays the sellers more for their shares than the exchange offers, charges the buyers less for shares than the exchange would, and keeps 5 cents for itself. Well, it keeps, say, 3 cents for itself, and sends 2 cents back to the retail broker who sent it the trade. The broker has subcontracted the internalizing job to the wholesaler, and they share the profits.

 

This is not actually an accurate description of the mechanics, because in fact a million orders don’t all come in at once. The U.S. equities trading day has 6.5 hours, which is a lot of milliseconds, and the odds of even two offsetting trades coming to a broker in any particular millisecond are low. People want their trades executed quickly and at the current market price; it would not be okay for your broker (or the wholesaler) to just sit on your order for a few hours—as the market moved—until it accumulated enough orders to match them all up.

 

But the key insight is that you can model it as though this were true. If the wholesaler gets a retail buy order now, it will probably get an offsetting sell order in 10 milliseconds or 10 seconds or 10 minutes. If the buy order can be filled at $58.15 now, the offsetting sell can probably be filled at $58.10 later, so the wholesaler can make its 5 cents. So the wholesaler executes the trades for its own account, out of inventory: If a retail sell order comes in, the wholesaler buys the shares and owns them for a little while; eventually a buy order comes in and takes the shares off the wholesaler’s hands. The wholesaler bridges the time gap between buyers and sellers. It uses its balance sheet to buy the stocks people want to sell and sell the stocks people want to buy, confident that over the course of the day those desires will mostly offset and it will make its spread.

 

Because it uses its balance sheet, the wholesaler takes price risk: If it sells stock for $58.15 now, and the price of the stock goes up in the next 10 seconds, it might have to buy the stock at $60.10 later, losing $1.95 on the trade, oops. But of course if it had sold stock first and bought stock later, it would have made $1.95. With enough retail trades, this should all balance out, and the wholesaler will mostly just earn the spread.

 

If the retail trades are random. If retail traders usually buy before the stock goes up, and sell before the stock goes down, the wholesaler would consistently lose money on price risk. (This is called “adverse selection.”) But they don’t. Even now, retail traders tend to be small, dispersed and uninformed. If you sell stock to a retail trader for $58.15, you have no particular reason to think it will go up (or down). The retail traders are trading randomly, which is what allows you to treat this problem as though you were matching them up with each other at a fixed price and collecting a spread. In reality you are matching them up with each other over time, not simultaneously, and the price moves while you are doing it, but the randomness of their trading means that this difference doesn’t matter too much.

 

Meanwhile market makers on the public exchange are doing something similar, but with institutional traders who tend to be informed and trade large lots of stock, so their trading does carry a lot more risk of adverse selection. If a big institution buys some stock, that does mean the stock is somewhat more likely to go up, so if you sell them the stock you are somewhat more likely to lose money. This is why the spread on the public exchange—the difference between the $58 best bid to buy the stock and the $58.25 best offer to sell the stock—is so much wider than the 5 cents that the wholesaler charges. The wholesaler is just matching up small pleasant random orders and clipping a spread; the stock-exchange market maker is facing a real risk of being run over by an informed trader.

 

And so this has developed into a market practice. Retail brokers send their customer orders to wholesalers. The wholesalers fill the orders at a price better than the “national best bid and offer” on the stock exchange: If the stock is quoted at $58 bid, $58.25 offered on the exchange, the wholesaler might pay $58.10 to buy it and charge $58.15 to sell it. This is called “price improvement.” The wholesaler pockets the rest of the spread (the 5 cents), but it also writes a check to the broker for the broker’s trouble (the 2 cents in my example). This is called “payment for order flow,” or “PFOF,” though sometimes people use that term loosely to describe this whole system of internalization. The numbers I am using here are fake, and the breakdown will depend on the stock involved, the brokerage, etc. But we can very roughly assume that, of the value that the wholesaler provides, about 80% is paid to customers in the form of price improvement and about 20% is paid to the broker in the form of payment for order flow.[4]

 

Now of course I am oversimplifying. For one thing, the wholesalers don’t have to fill every order out of inventory; they will do that with some orders and pass others on to the exchange to execute. They do not provide price improvement on 100% of orders, though they do compete to provide price improvement and are evaluated by brokers based on how much they provide. They will often lay off risk on the public markets rather than trading exclusively with retail customers; often they will be in the business of market making on the exchanges too, and will manage that business and the retail business in some interacting way. Anyone who trades a lot of stock benefits from having information about order flow, and a wholesaler who sees a lot of retail orders will have some informational advantages in its public trading. (Not necessarily that much advantage, if retail orders are random, but some. The other day I published some Citadel Securities data showing that in fact retail traders were net sellers of GameStop stock for much of last week. That data was surprising to me! The popular narrative was that retail traders were buying GameStop hand over fist, but that turned out to be not quite right. Citadel Securities knew the real story.) There are various glitches and curlicues and pockets of unfairness that wholesalers sometimes exploit, and sometimes they get in trouble for this. But for the most part what I wrote above explains (1) how it works and (2) the economic intuition behind it.

 

I feel like most of what I read about payment for order flow is insane? Otherwise normal people will start out mainstream explainer articles by saying, like, “Robinhood sells your order to Citadel so Citadel can front-run it.” No! First of all, it is illegal to front-run your order, and the Securities and Exchange Commission does, you know, keep an eye on this stuff. Second, the wholesaler is ordinarily filling your order at a price that is better than what’s available in the public market, so “front-running”—going out and buying on the stock exchange and then turning around and selling to you at a profit—doesn’t work.[5] Third, because retail orders are generally uninformative, the wholesaler is not rubbing its hands together being like “bwahahaha now I know that Matt Levine is buying GameStop, it will definitely go up, I must buy a ton of it before he gets any!”[6] The whole story is widely accepted but also completely transparent nonsense.

 

One more piece of background about payment for order flow. A few years back, Robinhood Markets Inc. had a crucial insight: Instead of charging a $5 commission and passing along 80% of the wholesaler’s discount to customers in the form of price improvement, it could charge no commission and pass along 20%, keeping the other 80% for itself. This, I have argued, was basically a smart marketing decision that saved its customers a lot of money and that Robinhood should have bragged about, but instead they lied and were squirrelly about it and got in trouble with the SEC. Presumably they have mended their ways, stopped lying about it, and are closer to industry-standard splits now. But they still take PFOF (like most retail brokers), and they still don’t charge commissions.

 

And their original insight caused a lasting change to the retail brokerage business. Free trades really were a lot more appealing than $5 trades. This model attracted customers to Robinhood, which quickly became the hot brokerage for the young trading-on-their-phones crowd. It pressured other retail brokerages to do away with commissions too, and eventually most did; now the norm, if you want to trade stock, is that you can do it for free. Also, intuitively, it is good for volume: If it costs you $5 to trade stock, you will feel some friction; you won’t want to sit around trading stocks frantically all day, because those $5 charges add up. If it costs you $0 to trade stock, there is no friction, and if you don’t have a lot else going on—say during a pandemic-induced lockdown—you really might sit around all day trading stocks. Since your broker gets some PFOF on every order, this is good for your broker: Doing 100 free trades, each with a bit of PFOF, is probably better for the broker than doing one $5 trade.

 

I wrote yesterday that, as the GameStop thing unwinds, people are going to be mad and want to do something about it, and that there will be “a focus on irrelevancies, a sort of ‘we have to do something, this is something’ approach.” Banning or restricting payment for order flow does seem to be on the list of somethings. Andrew Ross Sorkin proposed banning it in a column this week. And here’s the Wall Street Journal with a roundup of complaints:

 

Some Silicon Valley investors, including Benchmark Capital partner Bill Gurley and the billionaire former Facebook Inc. executive Chamath Palihapitiya, attacked payment for order flow on Twitter. Mr. Gurley urged the Securities and Exchange Commission to end the practice, writing on Sunday: “If the SEC/government wants to ‘fix the plumbing’ the number one thing they should do is ban Payment for Order Flow.”

 

Payment for order flow is likely to come up at a House Financial Services Committee hearing on Feb. 18 devoted to the GameStop episode, said Rep. Al Green (D., Texas), a member of the committee.

 

I don’t exactly get it, but I don’t get almost anything that is written about PFOF, so that is no surprise. But it might be worth laying out what “banning payment for order flow” could mean. I think there are three things it could mean.

 

1. Banning payment for order flow. One thing it could mean is that wholesalers are no longer allowed to pay brokers for their order flow. Everything else would remain as it was. The industry standard now seems to be that wholesalers give retail brokers roughly 80% price improvement and 20% PFOF; you could just write a rule that says “brokers have to pass on 100% in the form of price improvement, you can’t take payment for order flow, because that feels like a bribe.”

 

This rule would probably be fine? It would force wholesalers to compete, and brokers to evaluate them, on their ability to provide price improvement. Currently retail brokers have an obligation to provide “best execution” to their customers, which they generally fulfill by routing orders to wholesalers and carefully monitoring how much price improvement those wholesalers provide. But this interacts awkwardly with the fact that they’re also getting PFOF, and the fact that the PFOF sort of necessarily reduces the price improvement. (It’s all one pot of money that can be split however the brokers and wholesalers agree.) Getting rid of PFOF would make the evaluation simpler and less conflicted: You just route orders to the wholesalers who provide the best price for your customers, without worrying about who’s paying you more.

 

I don’t think this would materially change much about the structure of U.S. equity markets: Brokers would still route orders to wholesalers (because they want to get price improvement for their customers), wholesalers would still execute most retail stock trades, and wholesalers would still have a good and profitable though competitive business.

 

But there would be one big change, which is that retail brokers would have less money: Payment for order flow is a revenue source, and they’d lose it. This might force them to charge commissions again. Or it might not? Patrick McKenzie once pointed out that “57% of Schwab’s revenues are from net interest. The firm could literally give away every other service; discount the mutual fund fees to zero, do away with commissions, etc etc, and they would still be profitable.” That is no longer quite so true,[7] but I think you could still imagine a discount-brokerage business model that didn’t require either commissions or payment for order flow.

 

On the other hand I’m not sure you’d want to. The Robinhood model is good for brokers because (1) it gets them a little bit of money on each trade and (2) it encourages a lot of trades. If you get rid of (1)—if there’s no per-trade payment to the broker—then the brokers have less reason to want a ton of trading, and so less reason to keep commissions at zero. Still, if one broker can keep them at zero, that’s going to be a competitive advantage in attracting customers, and you still make money from customers (even if not from trades). So there will be competitive pressure to keep commissions at zero, and it’s at least possible that someone will figure out how to do it.

 

2. Ban internalization. To the extent your complaint about payment for order flow is that brokers shouldn’t route retail orders to wholesalers, but should instead send all orders to the stock exchange where they belong, then you could make a rule to say that. Banning PFOF, by itself, would presumably not change the order flow going to wholesalers: Retail brokers seeking best execution of their customers’ orders would still send those orders to wholesalers, because those wholesalers offer price improvement over the prices available on the stock exchange.

 

In fact the SEC case against Robinhood sort of implies that brokers have to do this, that they are required to seek price improvement and so can’t just take the publicly available price on the stock exchange. That overstates things: The stock exchanges do compete for retail orders by trying to segregate them from institutional orders and giving them price improvement. The New York Stock Exchange, for instance, has a “Retail Liquidity Program,” and you can sort of think of it as internalization but on the stock exchange. “Liquidity providers”—high-frequency trading firms—compete to offer price improvement to retail orders that come to the exchange’s program. It’s the same basic structure I laid out above, but on the exchange.

 

You could have a rule like “any time a broker gets a retail order, it has to send it to the public stock exchange instead of internalizing it.”

 

A rule like this really could change equity market structure. It would be great for exchanges, the for-profit oligopoly that handles stock trading; they’d execute many more trades and collect many more fees. Trading would be even more expensive for brokers, making it even more likely that they’d have to go back to charging commissions. I’m not sure it would matter much otherwise; perhaps the exchanges’ retail programs would fully substitute for internalization, retail traders would get price improvement similar to what they get now, and the result would be similar to the first version, banning only PFOF.

 

Or perhaps you’d get rid of even those programs and lump all orders together on the exchange, anonymously, so that any trade a market maker does might be with a giant hedge fund or with me buying 10 shares.[9] The rough intuitive result would be that big institutions would face lower trading costs, while retail investors would face higher costs: If you blend everyone together, the risk of adverse selection is somewhere between where it is on the exchange now (all institutions) and where it is for wholesalers now (all retail), so the spread will be somewhere in between too. Public spreads will go down, which is good for institutions, but retail investors won’t get price improvement, so they’ll pay more.

 

This would be good for institutions, which means me, because despite some hypothetical examples above I don’t actually trade stocks; I own boring index funds. Lots of people do. To the extent that the lesson of GameStop is “people are having way too much fun trading stocks and should buy boring index funds instead,” maybe it would be good to push them in that direction.

 

3. Banning zero commissions. To the extent your complaint about payment for order flow is that it enables zero-commission online retail trading, and zero-commission online retail trading is bad, you could just … ban that? Directly? Instead of banning a different thing that might or might not result in the return of brokerage commissions?

 

Like I recognize of course that there is an emotional appeal to “forbid shady kickback payments to brokers from evil high-frequency trading firms who are front-running your orders,” and no emotional appeal at all to “forbid brokers from giving their customers a free service.” It is politically terrible to go back to the days of regulated commissions, to make retail traders pay more, to de-democratize finance. It is not going to happen! No one is going to announce a rule like “trades can’t be free now sorry, you gotta charge at least $5 per trade.”

 

Still, if you think that “the problem in GameStop was PFOF,” surely this is what you actually mean? The problem in GameStop was not that retail traders got slightly better executions by having their orders routed to electronic wholesalers, or any conspiracy between those wholesalers and short sellers and Robinhood or whatever. The problem in GameStop was that way too many retail traders made way too many dumb trades, and if there was some friction maybe they would not have.

 

Of course there is a trade-off here, and it is not at all obvious how much the government should do to prevent retail traders from making dumb trades. One possible reaction to GameStop would be, like, “you can’t trade individual stocks unless you are an institutional investor,” and that probably goes too far. Charging five bucks a trade is a much milder reaction, but still it also probably goes too far for U.S. politics.

 

How’s GameStop doing?

GameStop Corp. (GME) common stock closed yesterday at $53.50, down 42%. It’s having a nice little rally today, trading at around $70 at 11 a.m. Even at $53.50, it’s up 184% on the year.

 

On Reddit, someone asked if Elon Musk is going to buy GameStop, and they are correct that that would be the funniest possible ending to all of this.[10] I joked last week that he should do this, but that by this week he wouldn’t be able to afford it. That was when GameStop traded at an equity market capitalization of about $25 billion. Now it’s about $5 billion. He can totally afford it. He should do it. Convert all the mall locations into Elon Merch Stores, selling flamethrowers and satin shorts.

 

This is not investment advice. If you are thinking about sinking your last dollar into GameStop, do not do it because someone on the internet made some jokes about Elon Musk. I should not have to say this, but we are living in weird times.

 

On the other hand if you are Elon Musk and you are reading this, sure, this is investment advice, get to work, YOLO.

 

As of this morning it seems that there are 8.6 million people on Reddit’s WallStreetBets forum. If each of them is the main character of exactly one movie about GameStop, there will be 8.6 million movies about GameStop and WallStreetBets. As of right now that strikes me as an underestimate. But some redditors are worried:

 

By Thursday morning, that quest for Hollywood riches had exploded into an ugly battle, giving a glimpse into the unruly nature of a suddenly famous Reddit community.

 

That was when the WallStreetBets moderators who were considering the film deal began booting out other moderators who had questioned them for secretly trying to profit from the forum’s success. Eventually, employees at Reddit weighed in to try to quell the unrest. …

 

Over the last week, several top moderators, who have administrative control of the message board, met in a private chat room on Discord to discuss the business opportunities arising from their sudden fame.

 

One moderator said he was in touch with Ben Mezrich, an author of the book that became the movie “The Social Network,” who last week secured deals to write a book and help with a movie about the GameStop saga, according to screenshots from the forum shared with The Times.

 

“Oof we gotta go fast i think,” another moderator wrote back. “While the studios are competing.”

 

In all seriousness there will only be, like, 30 or 40 GameStop movies, tops, so they are right to want to move fast. My basic model of the GameStop trade is that of a pump-and-dump: If you are going to get into a stock at a wildly inflated price, you’d better make sure that you can get out before everyone else does. The same basic model applies to the GameStop movies. If you are going to get into a crazy stock trade that gets made into dozens of movies, you’d better get attached to one of those movies before everyone else does. The real bagholders will be the ones who don’t sell their rights to Hollywood.

 

We’ve talked around here about Sarah Meyohas, the artist who once sat in a gallery manipulating penny stocks and painting their price charts on canvas, then sold the paintings for $10,000 each. One lesson here is that you can afford to lose money on your trading if you package it into art and sell the art for more than you lost. I am not sure that Hollywood has enough money to cover WallStreetBets’ GameStop losses, but it has a lot of money, and it seems to be spending a large chunk of it on GameStop? Perhaps the ultimate buyers who will rescue the GameStop diamond hands are not squeezed short sellers or delta-hedging options dealers or index funds or Elon Musk, but the movies. I hope that is a plot point in the movies; like, with five minutes left, the protagonist is in despair, about to lose his house, and then a Hollywood producer shows up with a bag of money offering to buy the rights to his story.

 

How’s the securities lending market doing?

This made me laugh, and I am not a person who usually laughs at monthly updates on the state of securities finance:

 

Global securities lending revenues totaled $979m in January, a 24% YoY increase. That marks the fifth consecutive month of increasing global returns. The month ended with short-squeeze fireworks, which also had the impact of boosting on-loan balances in many hard to borrow shares, a substantial boost to US equity revenues. In this note we will review revenue drivers from January, a cracking start to the new year. ...

 

The most revenue generating US equity in January 2021 was GameStop (GME) with $41m, generated largely as the result of the share price increasing 1,600% over the course of the month. The GME borrow fee did increase amid the volatility, however it remained lower than peak fees observed around the proxy record date in 2020.

 

The GameStop short squeeze was a high-stakes battle between Reddit traders who were long the stock and hedge funds who were short, an intense struggle to see who would give up first and lose everything. But also it was a way for banks and stock lenders to stand to one side and make so much money. The house usually wins, is an important lesson here.

 

Not everything is securities fraud

We talked the other day about a Supreme Court case to decide whether or not shareholders of a company can sue for securities fraud if (1) the company makes general statements about how it is ethical and nice, (2) it does a bad thing, and (3) the stock drops. The plaintiffs’ theory is that the general statements were lies, the company is not ethical or nice, the shareholders were deceived into buying the stock, and they lost money when the company’s badness was revealed and the stock dropped. The defendants’ theory is, come on, you didn’t buy the stock because of our ethics policy, this is not actually securities fraud.

 

This case is going to the Supreme Court because plaintiffs have had a fair amount of success in bringing cases like this, but it’s not universal:

 

In an opinion [Wednesday], Judge Wood dismissed a securities fraud case against Papa John’s that arose from two articles in Forbes in 2018 (see here and here), describing (among other things) an allegedly “toxic” culture of workplace sexual harassment.  The stock price dropped after the articles were published, and the theory of the complaint was that investors had been deceived by various public statements portraying a different culture—such as the company Code of Ethics stating that Papa John’s was governed by “principles of honesty, fairness, mutual respect, trustworthiness, courage and personal and professional commitment.”

 

Judge Wood had dismissed an earlier version of the complaint, and in yesterday’s opinion, concluded that the amended version still failed to state a claim because the statements at issue were “vague, broad, and merely aspirational.”

 

Things happen

The Rise and Fall of Bitcoin Billionaire Arthur Hayes. Robinhood's Lucrative Options-Trading Platform Attracts Mounting Scrutiny. Everything is securities fraud podcast. Credit Suisse Was Alerted to Private Banker’s Misconduct Years Before Criminal Charges. The Lousy Tippers of the Trump Administration. NBA Top Shot NFT Sales Surpasses CryptoKitties. Woman named Hedges-Stocks goes viral on Twitter during GameStop frenzy. 81-person French orgy broken up for violating  COVID-19 curfew.

 

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[1] Here’s a good Planet Money episode about it. My description above is informed by a discussion I had with Mary Childs, one of the hosts of that episode.

 

[2] The fees vary by exchange and various other details, but they are capped by regulation at 30 “mils” (hundredths of a cent), or $0.0030 per share.

 

[3] “High-frequency trader” generally means a proprietary trading firm that uses computers to trade really frequently. Internalizing is one HFT function, but there are others (on-exchange HFT, futures and ETF arbitrages, etc.). The big internalizers—who also generally have other HFT-y businesses—are a subset of the business usually called “HFT.” But if you’re a retail trader they’re the most salient subset.

 

[4] I think? That split comes from a Securities and Exchange Commission order against Robinhood, which basically cites a secondhand rumor about it: “At least one principal trading firm communicated to Robinhood that large retail broker-dealers that receive payment for order flow typically receive four times as much price improvement for customers than they do payment for order flow for themselves—an 80/20 split of the value between price improvement and payment for order flow.”

 

[5] I suppose if they could buy at the bid in the public market (because they are a market maker and get hit on their bids) and sell to you at (lower than) the offer then it would work. But that’s not really front-running? That’s just … you’re getting the stock cheaper than the public price anyway?

 

[6] Fourth, it’s not *Citadel*, the hedge fund, but *Citadel Securities*, the market maker, a different though affiliated company. The connection between the two led to a lot of conspiracy theorizing around GameStop, because Citadel Securities executes a lot of retail trades (including for Robinhood), while Citadel the hedge fund invested in Melvin Capital, the hedge fund that got hit hard by shorting GameStop.

 

[7] Charles Schwab Corp. reported net interest revenue of $6.1 billion for 2020, versus total expenses of $7.4 billion, so it could not currently run profitably just on net interest income. But if you add asset management fees—Schwab does a lot of asset management—you’re well into the black. Interactive Brokers Group Inc. made more in net interest last quarter than it paid in total expenses, though not for full-year 2020. TD Ameritrade and E*Trade are no longer public companies—they were driven into mergers by, basically, the zero-fee revolution—so it’s harder to get a full picture of the industry than it used to be.

 

[8] I can’t really recount the GameStop saga here, but if you for some reason are reading this in the future, maybe look, uh, here, here, here, here, here, here, here, here or here. Here in the present, I assume you’ve been following along.

 

[9] Institutions, of course, have their own off-exchange trading venues, called “dark pools,” but that is a separate issue.

 

[10] Actually a Chamath Palihapitiya SPAC acquiring GameStop would be the funniest possible ending but even less likely.

 

906.


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