Payment For Order Flow: Retail Traders’ Victim Mentality

Introduction

Payment for order flow (PFOF) is Wall Street wholesalers’ payment of retail brokers for unfilled retail orders. These orders are filled, almost always, at a better price than the regulators’ version of the best price in the market – an SEC-generated price called the National Best Bid and Offer (NBBO). So why is prohibiting PFOF the primary focus of the SEC’s campaign to fix the badly malfunctioning National Market System (NMS)?

This article questions whether PFOF deserves prohibition at all. The evidence suggests that PFOF is neither an abuse of retail investors nor important enough to get the attention it has attracted.

Grandstanding politicians and manipulated journalists have not looked closely enough at PFOF, dazed by the needlessly complicated NMS, and blinded by the bad optics of PFOF. Within the NMS chamber of horrors, plainly PFOF (which is now part of the process of filling most retail orders) is less abusive to investors than the ridiculously costly inefficient stock exchanges, which now primarily fill only the orders of algorithm-driven computers.

Humans, both retail and institutional traders, use other systems than stock exchanges because exchanges are too busy with the algorithm-generated orders of co-located computers. It is the bizarre fall of the exchanges into near-irrelevance to the investing public that makes OTC fills by wholesalers an improvement on retail fills sent directly to exchanges by their brokers.

Most important, retail traders’ victim mentality leads them to appeal to the same regulators who created this mess for a fix for even imagined maladies like PFOF. And regulators dutifully respond with new regulations, further complicating the absurdly complex NMS.

If retail traders instead took responsibility for the quality of their market service, there are obvious steps they could take to fix their problems themselves.

Through the looking glass

Maybe the posturing politicians who self-righteously attack Wall Street are right. Maybe Wall Street overcharges retail investors for brokerage services. But the counterargument that retail traders get fair treatment and pay the resource cost of trading or less, should have its day in court. The public discussion of Retail’s treatment by Wall Street has focused on payment for order flow (PFOF) since the meme fiasco of January 2021. This article examines PFOF from the other side of the looking glass – from Wall Street’s point of view – and reaches a surprising conclusion.

Certainly, the fog of complexity that is our securities marketplace renders definitive fact-finding about the resource cost of PFOF impossible. And balanced examinations of this political hot potato are hard to find.

My conclusion is that PFOF is most likely a fairly priced part of the retail securities market structure.

But logic and argument are not enough to exonerate PFOF. It must come down to the numbers. But the identification of the actual revenue and cost of trading with and without PFOF that would resolve the matter is impossible because some of the prices that lead to an answer are unrecorded.

Thus, PFOF shares with other securities market practice a key background financial system issue. Needless complexity is the overriding failure of our market structure making an evaluation of other possible failures impossible.

In other words, PFOF does not require a separate spotlight. PFOF, like most Wall Street interactions with Retail, obfuscates the costs and benefits of retail trading. Simplification of the system must be addressed first before efficient market practice can be identified with confidence.

• Both the SEC and Wall Street could be helpful to all parties by simplifying NMS. But in fairness to the SEC, how can a regulation simplify? Don’t new regulations inevitably complicate matters?
• And forget simplification from Wall Street which benefits enormously by burying trading costs in NMS complexities.
• But, more importantly, if retail traders took the initiative, they could simplify and improve the market structure of retail trading by themselves. Day traders have proven that with their venue, the futures markets.

Who is Retail?

Retail investors are an enormous force in financial markets. Here are some relevant metrics. Read here for more.

• Retail holds roughly 80% of equities directly, and through the institutions like pension funds that represent them, another 11%.
• Retail trades infrequently and is a smaller (roughly 20% but growing) share of stock market volume. Most of the stock market volume is algorithm-driven computer trades. No direct human involvement.
• Retail trades without the aid of computerized algorithms.
• Retail investors have different and simpler needs than institutional investors.

But the heart of the matter is that Retail is less informed about the quality of its services than investment professionals and day traders. Retail investors don’t know whether they get equal treatment. The retail securities market is not quite Roman “bread and circuses” but close.

The distorted public perception of Wall Street through the lens of the meme fiasco

The meme fiasco shined an unwelcome light on retail investing at the low end of the wealth spectrum. In this sector of the retail investment space, “bread and circuses” is a completely apt description. A variety of possible abuses were revealed in the wake of the January 2021 fiasco. PFOF got most of the public attention.

The optics of PFOF are awful. The appearance is that PFOF is payola, rather than payment for services rendered to wholesalers by retail brokers. The ugly optics knocked zero-brokerage-fee retail brokers like Robinhood (HOOD) off their pedestals and cast wholesalers like Citadel as charlatans.

The politics of retail trading

There is a new governmental retail securities market agenda since the splashy January 2021 meme fiasco. The five complaints of Retail:

• High exchange fees
• Payments for order flow (PFOF)
• Systematically inferior fills
• Lost securities loan income
• High-interest cost margin loans

These are the costs that may abuse retail investors. But only PFOF gets the attention of the SEC.

Resource costs and prices of retail transactions

What are the revenue and cost realities of PFOF? PFOF is paid by wholesale broker-dealers for the flow of customer orders from retail brokers. PFOF is revenue from the point of view of a retail trader’s broker. It affects the retail cost of a trade in several ways.

• The broker’s PFOF revenue may be passed through, in part, to the customer. For example, when a retail broker reduces or eliminates brokerage fees.
• PFOF affects the customer’s execution price, arguably for the better, when compared to the alternative price, the price that the retail broker could get by entering the trade at an exchange.
• But this difference between the retail customer’s price and the best available is opaque to a retail trader.

The argument that PFOF is unambiguously an excess cost to retail traders is based on the observation that PFOF is profitable for wholesalers. The argument should be more careful. The relevant securities prices in considering the fairness of PFOF to retail traders with the alternatives are these.

• The security price to the retail customer with PFOF.
• The best price at the time of the trade, according to the NBBO.
• The unknown cost to the wholesaler of reversing the acquired retail trade (buying to offset a sale to Retail).
• The unknown cost of the security if the order was instead filled directly by the retail broker through an exchange.

The last two prices are not observable. But the reason that PFOF exists is that Wall Street believes that wholesalers pay less for an inside market fill than do retail brokers. Even so, the net benefit of PFOF to retail customers is unobservable.

Thus, there is no definitive answer to PFOF’s effect on retail traders’ costs in the current outrageously complicated National Market System (‘NMS’). But there have been examinations of the evidence.

Matt Levine, here, and Eva Szalay, here, discuss a paper: “The ‘Actual Retail Price’ of Equity Trades” to be found here. Long story short, the paper’s authors conclude that PFOF is not a simple matter. PFOF (in the study) performed better than retail broker direct exchange execution. Interestingly according to the study, the effect of PFOF on retail cost of trading depends on

• The identity of the retail broker
• The identity of the wholesaler

But it does not depend on how much the wholesaler is paid! Moreover, for retail brokers, the rank of price improvement of PFOF is the same for each retail broker regardless of its chosen wholesaler.

The results are consistent with a possible explanation that each retail broker has an average “customer profile” and that the customer profile, combined with what might be called “retail broker bundling efficiency” creates the value that wholesalers’ pay for with PFOF.

These are interesting results that are generally consistent with the idea that PFOF is successful because the exchanges have become so incredibly inefficient. But the bottom line of the study is this excerpt.

“Our findings, however, indicate that the current disclosure regime is insufficient and provides limited information regarding the quality of price execution across brokers. In practice, it is very hard to compare the actual retail price execution quality of different brokers. Self-reporting is haphazard and inconsistent across brokers.”

The Retail reality: The case for a separate retail system

One reality that falls outside the political and empirical debate is that Retail has simpler needs than institutions.

• Retail orders are almost always smaller than the sizes of the best inside market bid and offer.
• Retail trades infrequently, so algorithmic trading has no appeal.
• Small orders cost wholesalers more per dollar to service than the far larger orders of investment houses.

Wholesalers cannot cover their costs in the market for individual retail customer accounts and trading activity, so they don’t seek to compete with retail brokers for customer direct accounts.

One of the reasons wholesalers pay for order flow is that retail brokers sell orders in bundles large enough to interest wholesalers. The study suggests that the bundling process may be complicated. Some retail brokers have smaller average order sizes than others. We don’t know how or whether the size of bundles offered to wholesalers is a factor in the effectiveness of PFOF.

Moreover, the cost of bundling orders is invisible to retail traders because retail brokers accumulate bundles faster than in the blink of an eye. To retail investors, this is instant execution.

Retail’s victim mentality

Retail investors should apply the lesson Vanguard showed them about getting Retail a fair deal. The quality of financial market services has something to do with actual resource cost, but it has more to do with the best interest of the service provider. Vanguard revolutionized the investment fund industry by putting Retail in the driver’s seat.

Other financial market participants, most prominently institutions, are aware that they are the masters of their own fates. The institutions are aggressive in seeking market participants who will represent institutional needs exclusively.

Retail is the largest share of the market. Where are its efforts to meet its trading needs directly? Nowhere to be found.

How could Retail settle the dispute?

There are two steps for Retail to gain control of the quality and cost of securities market services.

• Know the exact cost of each transaction by creating a retail platform that makes this feasible.
• Own one of the providers in each node in the transaction that might otherwise be dominated by firms that profit from overcharging retail.

The simplest solution is obvious and has a precedent. A retail-controlled exchange with a captive portfolio manager and a captive broker-dealer. However, describing the solution is far easier than implementing it. For readers interested in the implementation, a selection of my many articles that describe the details are here, here, and here.

Building a trading platform that meets day traders’ needs specifically is exactly how day traders take care of their costs in the trading space. They control the futures markets – custom-built for their trading needs.

Conclusion

The new chair of the SEC promised to be an activist. If you believe regulations inevitably complicate a market, and you see the NMS’ complexity as its greatest failure, new regulations are not good news.

There is no persuasive case that PFOF is harmful to retail traders. The limited evidence suggests that PFOF is a better way for retail traders to get a fill than through an exchange.

Government regulation of securities markets has complicated NMS trading and clouded the question of trader’s costs. Retail will never get an efficient trading system unless it builds the system itself.