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You two are talking about different things. They are similar but the mechanics are different. IB's example is an internalization pool where liquidity providers
by mrchicity 10y ago
You two are talking about different things. They are similar but the mechanics are different. IB's example is an internalization pool where liquidity providers may post quotes and potentially fill within the NBBO when they have a desire to match/improve the quote.
The KCG and Citadel business is called wholesaling. A broker like Schwab has market orders or marketable limit orders from customers. They make an agreement with a wholesale market maker like Citadel to fill all of those orders up to a certain size possibly, within the NBBO, in exchange for a fee and some price improvement requirements.
So imagine you're Citadel. You have a stream of incoming orders that you commit to fill at the current market prices with a bit of improvement. If the order flow is small, you just sit on the delta waiting for flow in the other direction or trade out patiently on exchange to make a spread. If the flow becomes largely imbalanced, you can liquidate the delta aggressively on the public market to hedge at a very small cost. Say the NBBO is 100.50 bid 100.51 offer and you just sold 500 shares at 100.5099 and bought 2000 at 100.5001. You can dump the 1500 residual on the exchange bid or in dark pools, whatever, and all you lose is the price improvement you gave and fees, which are smaller than the spread you make on a "good" trade.
In effect, the wholesaler is cherry picking and getting a cheap option to make a spread. All the small retail trades that are easy to capture spread on get siphoned off the exchanges, and they're left with only the imbalanced toxic ones. This is good for the wholesaler, good for the retail trader (he gets a bit of price improvement and lower trading commission), bad for the exchanges, and bad for on-exchange market makers like most HFT firms.
It's arguably "fair" to price uninformed flows differently, it's very common in some markets like FX, but locking that up behind opaque pricing agreements where only a handful of firms participate isn't. Most market making firms would gladly compete to offer even more sub-penny price improvement to retail trades, and there are even a few exchange programs that tried to do this but never got much traction.
- yummyfajitas 10y agoEvery time I've looked into the mechanics of paying for order flow, it was just a pay-to-play dark pool with certain extra requirements (e.g. you must match X% of trades). Do you have documentation on a brokerage that provides some sort of "first peek" mechanics that might allow frontrunning? I think we are in agreement that the main purpose of buying order flow is to price discriminate based on delta toxicity.
- mrchicity 10y agoI am not saying the mechanics allow front-running. It is just different from a dark pool or exchange in that the wholesaler guarantees execution and has some discretion over how to provide it. It's not as if Schwab pings a bunch of internalizers to say "hey, can you fill this at the NBBO?" and then routes out themselves if nobody says yes. The wholesaler must fill the order whether they want it or not, and can either wear the delta, fill it from their own inventory, or execute in the market to facilitate the trade as riskless principal. The wholesaler gets contingent orders like stop market and stop limit orders and is responsible for executing them as well. It is more like having the retail broker outsource their execution similar to how a fund may have a bank desk execute orders on their behalf, except a bank desk usually has even more discretion over execution. Hate to link to the Themis blog, but they cite the SEC here describing how internalizers, not retail brokerages, routed sell orders out to exchanges on May 6th: http://blog.themistrading.com/2010/10/the-internalizers-and-the-flash-crash-let’s-talk-real-villains/ http://blog.themistrading.com/2010/10/the-internalizers-and-...
- shostack 10y agoYou seem pretty informed on this. I'm still an investing novice, but hoping you can give some insight here... Does the practice described in this article and what you are discussing ultimately have a negative impact on Joe Investor who is taking the Bogleheads approach and sitting on several index funds, dollar-cost averaging his contributions, and occasionally rebalancing (but ultimately following a "buy and hold" approach)? Could the outcome of this come back to hurt the Joe Investors of the world?
- tptacek 10y agoI'm not the person you asked, but since you invoked Bogle, you should know that Vanguard (a) uses wholesalers and (b) has publicly and repeatedly claimed that high-speed electronic market-makers have improved outcomes for their investors.
- shostack 10y agoThanks for the clarification Thomas. I'm still a bit fuzzy on the potential impact of wholesalers and such with regards to regular Joe '401k' Investor. I'd love to read more if there's any solid articles you're aware of that explain this. As a regular investor who is making his way through "A Random Walk Down Wallstreet," it is hard to look at how Wallstreet has behaved over the years and not feel paranoid that I'm being taken advantage of at every turn. Right now I like the Bogleheads approach to investing, and the logic behind it, but am interested in how even that approach is potentially being taken advantage of, and what those real risks are to investors of that philosophy. Or...is that even something to be worth getting concerned over and is there a bigger threat I should be focused on learning about?