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Market Surveillance 2.0: Beyond the Crisis

29 August 2014

HFT, Maker-Taker and Small Brokers: There Goes the Business Model

As the regulatory and technological requirements to compete in the capital markets have multiplied, many small brokers have built revenue from payment for order flow into their business models. For many of these firms, there is no Plan B.

There’s a story that President Lyndon Johnson used to tell about a schoolteacher applying for a job during the Great Depression. It seems the school board was divided on whether the Earth was flat or round, and in the teacher’s interview, the board members wanted to know how he taught it. The poor fellow needed a job so much that he said, “I can teach it either way.”

Since Michael Lewis’s “Flash Boys” created a firestorm over everything from high-frequency trading to payment for order flow (PFOF), I’ve wrestled to find my position on the subject. For a long time, I felt like that Depression-era schoolteacher; I thought I probably could sell it either way.

Today’s level of technology has allowed for innovation that was never imagined when many of the market’s regulations were put in place. I thought the rise of electronic trading was as natural as survival of the fittest – that HFTs and others are simply playing on the field on which they find themselves; that venue arbitrage is like water seeking its own level. But in reality, maybe it’s more like Ty Cobb sharpening his cleats.

[Related: “Take the Time to Understand the Complexities of the Markets”]

But doesn’t the maker-taker model allow the smaller, upstart venues to compete for order flow with the Big Boys? It’s kind of like revenue sharing in the NFL, which works for small market teams, like the Green Bay Packers, right? Or maybe it’s more like the athlete that starts using performance-enhancing drugs to be bigger and faster, and because he thinks everyone else is doing them?

The more I think about HFT and PFOF, the more I feel like I’m doing one of those word association exercises. When I hear HFTs described as “liquidity providers,” I think “man behind the curtain.” Proponents say, “Just like a specialist,” and I think, “Ticket scalpers.” When I hear “faster,” I think “front-running.”

Are the markets “rigged,” as Lewis asserts? Perhaps not like the proverbial magnet under the roulette table. But we must acknowledge they are most certainly flawed and exploitable. Except for the potential financial windfall for those able to pay for location and speed from basically cutting in line, what is HFT’s real benefit to the markets? And while PFOF may have begun as a way for ECNs to attract order flow, is the perverse conflict it creates for traders really a good trade-off? How can best execution be unaffected by these hidden costs?

The current market construct raises a lot of uncomfortable questions that have answers that are almost always bad. These questions lead to another one that Joe Saluzzi and Sal Arnuk at Themis Trading asked a while back: What happens if it all were to go away? And I have another one to add: Who will suffer the most if things change?

Change Is Coming

Senator Carl Levin’s recent letter to SEC calling for the end of PFOF pricing models is the latest of many recent regulatory salvos across the bow of the brokerage industry. Several prominent market participants have called for access fees to be reduced to around 5 mills to 6 mills. None of this is earth-shattering news, but the realities of these possible changes may hit in different ways than we may expect. While it’s anyone’s guess what the SEC will ultimately decide to do, the bottom line is that some firms should be looking for a new business model.

Take small brokers, for example. For a number of these firms, made up mostly of institutional agency and boutique trading operations, maker-taker rebates have been an important source of revenue. Many small firms build PFOF revenue into their business models. They view it as an offset to the cost of their trading infrastructure, and as a revenue add-on for stock buyback and transition execution businesses. I’m sure some firms may pass PFOF rebates associated with transitions through to their clients; but I would argue that most small firms do not.

[Related: “Banning Payment for Order Flow Would ‘Magnify Conflicts of Interest’: Larry Tabb”]

Although PFOF has been around since the 1990s, one of the side effects of Reg NMS was that brokers, to stay competitive, needed to connect to more venues than before, increasing FIX connectivity and OMS system costs. This has created an environment at many boutiques and agency shops where a trader may be financially incentivized to seek out the most favorable rebates when routing order flow. I recall a particular boutique firm where one trader handled all equity order flow for the entire firm. His job was to route to whatever venue had the highest rebate. The trader then received an override based on total rebates generated at month end.

I remember the first time an ECN salesperson paid me a visit. This particular vendor came bearing aggressive pricing and a list of order types so complicated that the vendor returned to my office later with laminated cheat sheets to help my traders decipher them. The one type of order that jumped out at me exposed my desk’s flow to “enhanced liquidity providers” (read: HFTs), which at the time was a new wrinkle for me. We got a much better deal to use that order type. But I had a few questions: 1) Who are these providers? 2) Why are they so interested in helping my desk? And, 3) what are they getting out of it? I never could really get a straight answer.  That told me everything I needed to know.

But before we grab the pitchforks and torches in an effort to storm the boutiques and agency firms, let’s keep a few things in mind. Just like everyone else in this game, boutiques and agency firms are playing on a field they did not create. In the past 15 years or so, these firms have had to adjust for decimalization, electrification of markets, algorithms, and Reg NMS – all the while struggling to keep up with the competition.

But unlike larger firms that were better equipped to absorb these additional IT costs, many small brokers found PFOF rebates to be a natural way to offset these new expenses. Even if the SEC decides to leave PFOF in place, taking access fees down to 5 or 6 cents, small firms will still take a hit, as the technology costs will still be there.

I guess this is just one more unintended consequence of innovation and regulation.

There is a reason for my certainty about the potential negative effect of this regulatory overhang on small firms in particular: I’ve operated in this universe. In a past life, I had responsibility for building out more than one equity desk from the ground up. The business model I’m describing isn’t theoretical.

It’s also why I’m fairly certain, that for many small firms, there is no Plan B.

This commentary originally appeared on the Hillcrest Strategies blog.

Spotlight-white-trans For more stories in the Market Surveillance 2.0: Beyond the Crisis Spotlight Series click here.

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5 Comments to "HFT, Maker-Taker and Small Brokers: There Goes the Business Model":
  • Missing

    02 September 2014

    The history has been that regulatory changes/burdens tend to concentrate business more and more at larger firms. No reason to expect that to be different now, with much bigger regulatory and technology costs being incurred as a permanent change to market structure.

  • Comment_msw_cropped

    02 September 2014

    I would agree that when it comes to the effect of regulatory change on small brokers, there seems to be a general blind spot on the part of regulators. On the other hand, I think that regulations such as Reg NMS, for example, created a number of perverse incentives across the board that are of more concern than the possible regulatory burden it may have caused for small firms.

  • Missing

    06 September 2014

    Marlon, loved the humorous opening salvo -- I may have to borrow that Johnson joke!  As to structure, brokers created the NYSE long before there was an SEC.  We need commerce. We don't need regulatory bodies, proof of which rests on the thousands of years that preceded the most recent 100 in human history where somehow common sense has given way to the silly notion that we need government rules for everything from cow farts to stock trades.  How refreshing it would be for traders, companies and investors to work it out themselves, as humans used to do. 

  • Comment_msw_cropped

    08 September 2014

    @timquast - Thanks so much for your comments.

    While I would agree that more commerce would be a good thing, I don't agree that regulation, in and of itself is the problem. I think what you site in your post as "proof" ignores a couple of things.

    The last 100 years or so have seen exponential progress. In terms of technological advancement, the average smartphone of today probably has more technology than the space module that landed on the moon. Keep in mind that the majority of trading today occurs with virtually no human involvement. The reality is that with this level progress, rules of engagement are necessary to insure fairness and order.

    I won't argue for or against the effectiveness of our current set of regulations, but I think it is important to consider that many of these rules are in response to various abuses by market participants. In fact, this is really nothing new. In the Tulip mania of the early 1600s, the speculators actually sought out help from the government to help bring order to the markets. Today, there is also a strong argument to be made that the lack of regulation, not over regulation, played a major role in the most recent financial crisis. 

    While it would be great if we could depend on ourselves as humans to simply "do the right thing" without rules or regulations as guidance, our history indicates that we have a less than stellar track record in that regard.


  • Missing

    08 September 2014

    Marlon, thanks!  Exponential technological progress without a corresponding improvement in wealth is confusing busy with productive. The Eurozone countries have average debt including unfunded liabilities of 400% of GDP. The US is at 700%, adding unfunded liabilities, which is more than all the wealth accumulated by its citizens. From a balance-sheet perspective, we're worth zero. Compare to the 19th century:  No increase in debt, explosive increase in wealth, 50% improvement in the CPI-equivalent.  We must be careful to not to buy "progress" according to incorrect metrics. 

    The tulip mania was merely a manifestation of the oldest of lessons on the relationship between money and things.  Thanks to vast shipments of silver and gold from the just-discovered New World, combined with free minting in Amsterdam, the amount of money in circulation exploded, leading to a curious outcome where people paid more for tulip bulbs than for the dirt in which they were grown. Inflation is always and everywhere a monetary phenomenon.  After all, the supply of people and bulbs didn't substantially change.  Just the price of things. 

    As to the effectiveness of regulation, take the Cincinnati stock exchange. It began as a place for investors to buy noteworthy companies like Kroger (in 1904 it had 5,000 stores nationally), the Baldwin Piano Co. and more. It succeeded until Congress decided in 1975 we needed a "national market system." Then it went electronic, moved to Chicago, changed its name, moved to Jersey City, got bought by the CBOE and then shut down in June of this year.  Why would the CSE move to Jersey City? Because all the exchanges are in boxes in Mahwah, Carteret, Weehawken, Jersey City, etc.

    Trading stuff with algorithms is not investment behavior.  It's a math problem. We have mistaken capital-formation for data, software and moving stuff around.  Sooner or later, this will catch up to us. 

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