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Fred and Ethel, Viagra, and the 2nd Derivative of Fragmentation

19

July, 2012

 

Fred and Ethel have been investing for years! They at one time had accounts at Merrill Lynch, and even an account at Fidelity which held their mutual funds. That all changed when they saw the commercial with the talking baby in the crib with the Blackberry and the vomit, and they opened up online accounts – but I digress. We are here today to talk about their needs as investors, and their biggest problem with the markets, and what keeps them up at night.

I know what you are thinking… “Jeez, not another story about the billions of lost investor money due to fraud from Madoff, the Peregrine guy, Corzine, AIG, Facebook, Enron, WorldCom, rating agency shenanigans, Goldman, the mortgage crisis, 0% interest on savings, Congressional insider trading, and high frequency trading….”

No. Fred and Ethel are kept up at night because they feel that they need a way to trade in sub-pennies. They lay awake staring at the ceiling dreaming of being price-improved by a tenth of a penny. You see, Fred and Ethel make an average of 8 stock trades per month, or 100 per year. The size of their average trade is 200 shares or about $5,000 in dollar terms, assuming an average stock price of $25 dollars. A tenth of a penny savings means that they would be able to buy 200 shares of Intel at $25.249 instead of $25.25, which would would save them $0.20 on a single $5,050 transaction, and about $20 dollars per year. Oh what Fred and Ethel could do with that $20 dollars. They could buy a breakfast at Dennys, or even use that $20 to pay for the copay for a Viagra scrip! Which is precisely why the caring folks, at the Stock Exchanges and the Securities and Exchange Commission have been creating real easy mechanisms and systems to find a way to get them that tenth of a penny.

Fred and Ethel were uneasy at first, as we sat down with them to explain them how our markets have been fragmented. “What? Repeat that. Say that again. I don’t hear so good. Sigma Sex?” They got over their uneasiness, however, and after a few weeks of our educating them, they got to a point where they are 80% there in terms of understanding how our stock markets now work. They almost get our diagram of market fragmentation, and how the system depicted in that diagram gets them penny spreads.

Fred:   Enough with the penny spreads Einstein. We got that. Tell us how we can save a 10th of a cent. Tell us how we can save 20 cents on a $5,000 transaction. Tell us how if we do that 100 times a year we can get frisky.

And so we told them. We told them more about the Dark Pools, and about the NYSE’s Retail Liquidity Program. We told them how order flow in the NYSE is about to become segmented - that the NYSE will identify new classes of brokers: retail member organizations and retail liquidity providers. We told Fred and Ethel that their retail orders would only interact with the special best friend forever (BFF) liquidity providers (doing God’s work and price-improving them a tenth of a penny), if they do in fact make it to the NYSE. They had more questions, which was understandable. After all, we are talking about calculus-second-derivative-fragmentation-stuff.

Fred:   Why would my order not go the NYSE?

Us:      The firm that you do online trading through, with the commercial with the vomiting baby, will sell your order, and rarely route it to an exchange first. They will sell it for two tenths of a penny to a high frequency market maker – like Citadel, Citigroup or Knight. The barfing baby will still probably do that most of the time, because they can only sell your order to the NYSE BFF retail liquidity providers for five hundredths of a penny, which is less for them.

Fred:   They are selling my order? Why would anyone pay to execute my order. That makes absolutely no sense, unless they were trading around and making money….WHOA stop right there! That’s down right meshuguh! The SEC allows this?

Us:      Yes, Fred, they allow it. They think this is good for you. They want you to have sex and to sleep at night. They want you to save a small fraction of a penny.

Ethel:  Hang on. When our order goes to the NYSE we still trade in that one market place, right?

Us:      Yes and no. Ethel, the stock exchange is becoming segmented. Your orders trade with Retail Liquidity Providers (RLPs) on the NYSE doing God’s work. Everyone else’s orders, like institutional brokers, and mutual funds, don’t trade with your order.

Ethel:  Umm… what if I don’t trust the RLPs? After all they are paying money to trade against me. That makes me nervous. And who knows. They might know things we don’t and we may get screwed every time we trade. And not screwed in a good way.

Us:      You will not have a choice. These decisions are made on your behalf. Your broker has beneficial financial arrangements, for them that is, with other brokers, and now the NYSE. This is the way it has to be if you want to save a tenth of a penny.

Fred:   I am not worried. I believe in America and competition. I fought in Korea you know. Surely other stock exchanges – you did say there were 14 of them – will offer a solution where folks who don’t care so much about saving a tenth of a penny don’t have to be segmented and singled out. I bet you one of the firms like BATS, DirectEdge, or even NASDAQ create one simple exchange where all orders, no matter be they from machines, retirees like Ethel and me, mutual funds, and even Warren Buffett trade in one place with the same rules for all and economic benefits for all.

Us:      Don’t make that bet, Fred.  We read an article on Bloomberg written by Nina Mehta about how NYSE’s RLP program has BATS, NASDAQ, etc. drawing up similar plans to segment customers on their exchanges and trade in sub-pennies. They will follow in the NYSE’s footsteps, and not compete by offering an alternative. In addition you can count all the internalizing brokerage firm “market makers” pushing the SEC so that they can now expand their sub-penny trading. Have you seen the article? Let us share some tidbits with you:

The Securities and Exchange Commission approved a pilot project to be started by NYSE on Aug. 1 to furnish individuals with prices at least one-tenth of a cent better than those available to mutual funds, high-frequency traders, brokers and other market participants. The program is aimed at helping NYSE to compete with so- called equity wholesalers, a category of market makers that executes orders for individuals sent to them by retail brokers such as TD Ameritrade Holding Corp. and Charles Schwab Corp.

BATS’s Joe Ratterman said, “This is a major, major fundamental shift or step in the direction of segmenting your customer base. While Bats would prefer that we hold to the old doctrine, clearly the SEC has paved the way for a change to that doctrine and we absolutely will respond. Exchanges historically provided “fair and open access” on the same terms to all participants. Now, they’re being allowed to offer “disproportionate economics and disproportionate access” based on participant type. While the SEC is permitting NYSE to give retail investors better prices, “it’s a slippery slope” that could allow exchanges to further differentiate between users.

William O’Brien, CEO of Direct Edge, called NYSE’s plan a “milestone” and said his company would offer a program to provide better prices and more shares to retail customers. What’s most significant about the SEC’s approval of NYSE’s program is the “ability of exchanges to provide targeted outcomes” for some users, O’Brien said. “The notion of fair access was that if you’re not doing it for everybody, you can’t do it for anybody. At least with retail investors, that’s clearly allowed now.”

The CEO of Knight, which has criticized NYSE’s plans to the SEC, said today that exchanges’ interest in bidding for retail orders is a “rush to the bottom” because it allows bid and offer quotes at increments less than 1 cent. That’s currently not permitted by the SEC since the disadvantages are seen as outweighing the benefits of minimally better prices. The SEC exempted NYSE’s and NYSE MKT’s programs from the ban.

NYSE’s Mecane said, “If you’re just trading and have no idea who you’re trading against, you’ll be less willing to make aggressive prices than you would be if you knew the other side wasn’t a proprietary trading firm.”

Thomas Peterffy, chairman and CEO of Interactive Brokers Group Inc., a Greenwich, Connecticut-based securities firm that operates a market-making unit, said NYSE’s program could backfire on retail investors by alienating market makers. Such traders may be less willing to quote aggressively on exchanges if others are getting slightly better, hidden prices, Peterffy said in a conference call yesterday. That could cause the bid-ask spread, or difference between the price at which traders are willing to buy and sell shares, to widen, yielding worse prices for investors, he said. Institutional investors such as mutual funds also won’t get the benefits of the retail programs that exchanges offer, according to Ratterman of Bats. While it’s important to give individuals the best trades possible, many people invest for their retirement through pension or mutual funds, which won’t have access to the better prices.

Ethel:  Cut to the chase. Is this good or bad?

Us:      Well, the SEC and the Exchanges all think this is good for you because you will save a tenth of a penny.

Ethel: A tenth of a penny off of what?

Us:      Off the quoted bid and ask.

Ethel:  But didn’t you tell us when we started talking with you a few weeks ago that that quote flickers and is like a star that we see, where it’s burned out by the time we actually see it? Like what happened in VVUS the day before yesterday, where it flash crashed?

Us:      Yes. You have a point. You are a great listener! Maybe you are saving a tenth of a penny. Maybe not.

Fred:   Hey. I’ll take a maybe any day of the week at my age! Ethel, what do you say we go into the other room – you and me?

Ethel:  Thanks SEC!

 

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