Raw Clay: What Happens If Payment For Order Flow Dies?



We have advocated for a long while that the markets should do away with the notion and acceptable practice of payment for order flow – pioneered by Bernie Madoff. Why? Simply it is a needless conflict of interest. The benefits it produces we believe do not outweigh the dangers to trust, confidence, and rules of fair play. If someone is paying you to be the other side of your order, are they doing it to give you the best price available, or are they doing it to feed their own profitability?

Recently, Washington DC is questioning the practice as well. Of course there are very large business models built around payment for order flow. It would be disruptive to those models if the practice were to be ended. However, that doesn’t mean that those firms that play in that arena will not adjust and adapt; they would not be the first  business models that have had to adjust.

Today we want to  throw down some  thoughts in raw form on how we might expect the marketplace to change, should the practice be banned. These are initial thoughts. We would love to collaborate with you all, and hear your input as well! What would a marketplace with no payment for order flow look like?

No Maker-Taker on Exchanges + No ping for a rebate (PFAR) and ping for a fill (PFAF) in SORs and Dark Pools + No Retail payment for order flow (PFOF).


 Retail: Retail orders from online brokers can no longer be sold. Order must be sent to trading destinations directly. Online brokers have the freedom to direct to dark pools or exchanges, except they are held to best execution standards (still NBBO).

Institutional:   Institutional larger orders still get broken up, either manually or by algorithms. Buyside traders and brokers working client orders still have the option to use whatever tools they desire to achieve best execution. They can use large block-crossing-oriented dark pools if they desire. They can use algorithms that send child orders to the market place directly, such as lit exchanges or broker dark pools, as they desire. Manning rules apply. Brokers cannot trade alongside or ahead of their own clients order flow (of course). “Heat Maps” can still are used to help guide execution destination.

Conflicts of interest:  Drastically reduced. There is no revenue to be gained by not solely acting as agent for the order initiator. TD Ameritrade doesn’t get to make some $200 million per year selling the free option to trade against their own customers’ orders. Agency brokers don’t get to make money by selling institutional child orders to ELPs for rebates either. Buyside traders and agency brokers don’t send orders to the highest rebate giving exchanges for limit orders, or to inverted exchanges that give rebates for marketable limit or market orders. Orders go to destinations based on their market pricing at the time. If NYSE is offered at $20, a limit buy order at $20 goes to NYSE. If BATS is offered at $20, a limit buy order at $20 goes to BATS.

Exchanges:     Differentiation between exchanges is made based on true innovation, as opposed to just pricing gimmicks. BATS competes with NASDAQ and NYSE based on price and liquidity. They are all free to charge what they wish in a take-fee format. Perhaps NYSE charges 10mils. Perhaps BATS charges 8 mils. Perhaps each exchange has pricing tiers, where Morgan Stanley is charged a lower rate to trade than a smaller agency broker, just as Hertz gets to buy a Ford cheaper than an individual. Exchanges also focus more on listing stocks for issuers – one of their original primary purposes. At the end of the day the market decides the appropriate number of exchanges that volume can support, based on how well each exchange meets the markets’ needs sand conflicts of interest. The number of exchanges will likely drop.

Dark Pools:    Differentiation between dark pools is made by true innovation. Batch auctions? Block-oriented? Blotter-scraping? Liquidity? Speed? Dark pools charge fee rates as they deem appropriate. Volume discounts apply, as they may on exchanges. At the end of the day the market decides the appropriate number of dark pools that volume can support, based on how well each exchange meets the markets’ needs sand conflicts of interest. The number of dark pools will likely drop.

Short Term Traders:            They can go as fast as they want, collocate as they wish, use microwave tech as they wish, or use cable dug through mountains and oceans as they wish. They may trade wherever they want. They will perhaps adjust their robots to buy when they think a stock will go up, and sell when they think it will go lower. The video game around being a maker versus a taker, and optimizing rebates, will disappear, as will all the complex order types in exchanges and dark pools that are designed to play that video game.

 Investors:       They can decide how fast they wish to trade, and which technology to use. They can choose broker accordingly as well. They can decide between millisecond immediacy of a smaller number of shares, or a more patient approach for a larger number of shares.

Brokers:         They can choose to trade proprietarily, or not. They can choose to commit capital to facilitate larger trades, or not. They can choose to own dark pools if they find it profitable. They can choose to focus on underwriting, and helping new companies get capital, or not.

Limit Order Books:   These will likely become deeper, with more diverse players. These should be robust during times of stress, with less “mini-flash-crashes” – or worse…

“Liquidity providers”:          We have an order driven market, where the originators of all of these orders are done for capitalistic reasons. Large fund managers want the most liquidity at the most advantageous prices for their large orders. They “provide liquidity” accordingly. Short term traders want to buy low and sell high over short, or even very short time periods. They “provide liquidity” accordingly. Incentives to provide liquidity are, and should be, simply driven by free market capitalistic desires to do so, no matter the participant. The free market will work out the correct amount of inter-mediation.

Spreads:         We would expect spreads to widen for large cap stocks, and probably remain close to unchanged for smaller cap stocks. For large caps, perhaps the bid ask spread widens from 1.4 cents per share to 2.5 cents per share. Perhaps. Maybe less. Maybe more. However, cost as measure by a spread becomes a very explicit cost, that represents true supply and demand in the marketplace among all types of traders and investors, without regard for holding periods.

Retail Commissions:  Perhaps they go up de-minimus. Perhaps $8 per trade goes to $12 per trade. However, the commission more accurately reflects a true and transparent cost of access to the marketplace. Note that even in today’s payment-for-order-flow-friendly environment, some retail brokers do not engage in the practice; they deem it to be inappropriate.  They still charge very low commissions.

Institutional Commissions:   Perhaps these rise. Supply and demand sets cost for low touch, high touch, and research. The commission more accurately reflects a true and transparent cost of access to the marketplace.

What do you think? Do you agree? What are your thoughts on how the market can collectively look without the existence of payment for order flow (PFOF) in general?

We would love to know how you weigh in; the above represents some raw clay we just slapped down on the work table.