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.