“Make-or-take pricing has significantly distorted trading,” wrote James Angel of Georgetown University in Washington, Lawrence Harris of the University of Southern California in Los Angeles and Chester Spatt of Carnegie Mellon University in Pittsburgh. “Brokers make most order-routing decisions based on the quoted prices that their clients will receive, and not the true net prices of the trades.”

This quote comes from a Business Week article on a recently produced report titled “Equity Trading in the 21st Century” http://www.businessweek.com/news/2010-02-24/brokerage-prices-don-t-reflect-actual-trading-costs-study-says.html 

We must admit that when we first saw the report which was commissioned by Knight Capital we didn’t expect to read any comments like the above comment.  Ever since our first white paper, we have recommended that the current make-or-take model distorts markets.  An entire industry has been created where some  high frequency traders simply trade to collect liquidity rebates.  There is no economic value added to this process.

But it appears the authors of this study have also hit on another major problem with the make-or-take model:  Some orders are not being routed to the destination where best execution would dictate but they are being routed to the cheapest destination first.  Most institutional algorithms uses a smart router to route orders in small pieces throughout the day.  The pecking order of these routers differs depending on which broker sponsors the algo.  But a common goal is always to route to the cheapest destination first.  Most of the time this means they route to a dark pool before a displayed liquidity venue.  This is where the predatory traders hide out and watch for footprints that these algos leave.   And the most unfortunate thing is that most of these algos have no idea that they are being gamed by these predators.