Payment for order flow has been around on Wall Street for a long time. Bernie Madoff was one of the pioneers of this practice. His firm, Madoff Securities, was known as the third market. They would pay other brokers a penny per share for market orders and then trade in between the NYSE specialist spread. Madoff was able to trade around 10% of volume with this arrangement and was able to make a lot of money.
Most online brokers today sell their market orders to “internalizers” who pay a fraction of a penny per share for the order (check out some 606 reports if you want to see how much of your brokers flow is being sold). These internalizers siphon order flow from the lit markets and get to pick and choose which orders they want to interact with. On May 6, 2010, many of the internalizers chose not to interact with these orders and shipped them to the lit market and we all know how that turned out.
Exchanges also pay for order flow with something called the maker/taker model. To capture more flow, exchanges will usually pay their largest clients (so called Mega or Ultra Tier clients) up to 1/3 penny per share for their limit orders. These rebates have helped to distort the price discovery function since many high frequency traders choose just to trade just for the rebate (just watch BAC stock if you want to see this in action).
Now, we get word that NASDAQ has a proposal to have companies that sponsor ETF’s pay market makers to quote those ETF’s. There are currently over 1500 ETF’s and many of them die each year due to the lack of volume. No volume means no fees for the ETF sponsor. Of course, these ETF engineers want to earn more fees and are now willing to give up a piece of their profits to encourage “market makers” to quote.
A good friend of Themis’, Tim Quast of ModernIR, was asked in a Bloomberg article about this new payment for order flow scheme:
“Trading shouldn’t be incentivized in one security in a different way than it is for other securities, Quast said. He said he doesn’t support payments to market makers to narrow the difference between bids and offers, price bands, trading curbs or other rules that limit share moves. ” All these are price-control mechanisms that conform behaviors to norms, which exacerbates arbitrage and diminishes investment and capital formation.”
Just more parlor games that create more synthetic arbitrage opportunities so the high speed gang can continue to pillage the fragmented equity market.
Oh, by the way, there is one small problem with NASDAQ’s plan: it’s illegal since FINRA banned payments to market makers in 1997. But if the SEC approves NASDAQ’s plan, which is known as Rule 5950 or the Market Quality Program , then FINRA plans to ease the rule. Amazing how rules can be broken when big bucks are on the line. If this new payment for order flow plan strikes you as odd or manipulative, make sure you tell the SEC with an official comment letter. Click
here to send your comment letter.