Trading Technology

01:41 PM
Justin Bouchard
Justin Bouchard

SEC In The Dark As Dark Pools Shine

The popularity of internalization is reducing liquidity, increasing costs, and harming investors.

This past Thursday, Mary Jo White, Chairman of the SEC, announced initiatives to monitor the HFTs, dark pools, and automated trading as concerns have raged ever since the release of Michael Lewis's book, Flash Boys.

The announcement included a new SEC committee to review market structure, propose rule changes and review key market regulations such as Reg NMS, which has essentially created the markets that we have today -- a tangled mesh connecting exchanges in order to achieve best price for the customer. While a review of Reg NMS is needed, it seems that the SEC has missed the point again. "The competition for order flow among these venues is intense, and it benefits investors by encouraging services that meet particular trading needs and by keeping trading fees low," the SEC said in a statement.

But if you go back to November 16, 2000, when the SEC passed rules requiring brokers to report where orders are sent and how they're filled. "The rule should greatly increase the opportunity for public investors to evaluate what happens to their orders after they are submitted to brokers," the SEC said in a statement. Arthur Levitt, in his final year as chairman had been sounding the alarm on the dangers of broker internalization. Levitt said that brokers who internalized had little incentive to improve on the best price of orders for customers. He also warned that payment for order flow from one broker/dealer to another was not generating best execution for customer orders. Instead of acting to prevent the practices, the Chairman may have chosen the safer political path as his time with the SEC was winding down. "Monitoring the situation" did very little back in 2000 and it won't do much good today.

Again, in 2005, instead of taking action to cure the disease, the SEC sought to treat the symptom. So, to give customers the "best price," they passed "The Consolidation Rules" later known as Reg NMS. The new rules, which included "order protection," required an exchange to reroute an order if a better price existed on another exchange.

Acting on the message that Mr. Levitt left for his successors years before, the SEC formalized his concept of best price, but had forgotten the main point: that orders should be executed on the exchange. The result created a new problem with predatory HFT. They didn't foresee the messy web of connectivity between exchanges that would result from Reg NMS.

New rules
One of Thursday's proposed changes is to have HFTs register as broker dealers in an attempt to gain higher oversight over them. However, that would complicate and fragment the market even more, as broker dealers have also engaged in questionable HFT practices. In fact, internalization is being automated and done at high speeds, so I consider the broker's practice as HFT -- although others may argue. Another proposal sure to be opposed by HFTs is a new anti-disruptive trading rule that would prevent short-term strategies that can harm the market. The unintentional consequence would mean less liquidity and it would also force market makers to trade larger positions to make up for the loss of frequency. Without the ability to trade quickly, market makers face a difficult challenge providing liquidity in uncertain markets and even slow markets.

In reviewing market structure, you don't have to trace the orders far to find major problems. When an average investor sends an order to their online broker, the broker will do one of several things with that order. Unfortunately, sending the order to an exchange is probably not one of them. Online broker/dealers, in most cases, are either sending orders to HFT market makers or internalizing the orders for their own profit. The practice is hurting our exchanges, hurting our professional traders, and most of all, it's hurting the liquidity of our markets. The major difference between HFT and internalizing is that internalizing takes liquidity away from the market. That's liquidity that we could have used during the "Flash Crash."

Tiny fractions of pennies
TD Ameritrade sends its orders to "market centers" like DirectEdge, Citadel, and Knight because they get paid up to $0.0035 per share, just over one third of a penny. These "market centers" (which can be called automated trading systems (ATS), dark pools, or market makers) will pay the broker for order flow in order to make easy profits on those orders. So even though TD charges $9.99 per trade, they claim that "this payment is used to offset the costs of doing business and ultimately helps to reduce the overall cost to our clients. So basically, the cost theoretically would have been $9.9935 if the order was sent to the exchange, but the broker is doing you a favor by sending it to a "market center" to save you the extra third of a penny. The funny thing about this is that we could just as easily use software provided by the "market center." Knight (KCG) has its own trading platform and is also a registered broker dealer.

Your broker can take the other side of your order and other orders that should go to the market. If you send a market order, your broker will most likely buy what you're selling because there is a chance they can make money off of it. When you place a passive bid or offer, it can sit in the market and as you wait for the price to come up to your offer to sell or down to your bid to buy. The longer you wait, the better the chance that your order will make it to the front of the line, but even if your order does make it to the front, the broker can step right in front of you without waiting so that they can take small profits on the no brainer orders. There are two problems with this practice: one is that it diminishes the role of the market maker and reduces liquidity because many orders don't make it to the market, and the second is that you might not get filled while the broker can buy the bid and sell the offer all day long. At least HFTs are providing market liquidity.

Because fewer orders are making it to the market, exchanges are looking for other ways to make money. Mainly, exchanges are charging higher fees for market data. This has created a huge barrier to entry for early stage Fintech startups and prevented Silicon Valley as a whole from breaking into the world of finance.

Online brokers will be the first to point out the "efficient market hypothesis," which boldly states that you can't beat the market, most money managers can't beat the market, and information is useless because events are priced into the market even before they happen. Why then do professional traders seek information as if their lives depend on it? Brokers do this so they don't have to spend money competing with professional traders to make the best trading software.

Even though professional traders are paying fractions (sometimes thousandths of a penny), online brokers still feel justified charging $10 per trade. That way, they can tell you that no algorithmic trading system can be profitable at the prices retail traders pay per trade.

Justin Bouchard is CEO of AlgoFast, a provider of high-speed, event-trading software for individual investors. He is also the founder of Bouchard Trading, a Chicago, Ill.-based firm focused on the trading of futures products on the CBOT, CME, CBOE, EUREX, LIFFE, ICE, NYMEX, ... View Full Bio
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User Rank: Author
6/11/2014 | 10:58:35 AM
What's the fate of internalization?
I don't think internalization is going away unless there is a regulatory mandate.Many retail brokers that send order flow to internalizers with ATSs claim they are getting the best price in the market. These firms are also receiving payment for order flow, so they are somewhat biased.

I think you are suggesting that the exchanges can offer their own software platforms to compete with the likes of Knight (KCG) and Citadel. I believe that exchanges have tried to offfer market-maker programs (ie., NYSE retail liquidity program) to attract flows that are being sent to broker owned ATSs.

One of the ways the SEC can deal with internalization is to test a trade-at rule that requires each ATS to improve the price over what's displayed in the lit market. This is part of a wide tick pilot the SEC plans to run for small cap stocks. While this is only a test of 'trade at' it could be more broadly implemented as a way to push trading volume back to exchanges and away from private trading venues. This could be the next stage in the battle between exchange and broker/bank-owned dark pools.

User Rank: Author
6/12/2014 | 2:52:42 PM
Re: What's the fate of internalization?
Thanks Ivy.  I view 'pay for order flow' and 'internalization' as two separate things, both resulting in orders never making it to the market, and by 'market' I mean one of the exchanges.

It is shocking to me that orders are not sent to the exchanges.  What good is Reg NMS, or any Securities and Exchange rule for that matter, if orders don't make it into the system?  Pay for order flow is allowable if the orders end up at a National Market System exchange.  

By definition, internalization will never be OK because the orders will never make it to the market.   Here's TD Ameritrade's definition:

"What is internalization?Internalization is the practice of a broker sending a client's order to another division or affiliate of the broker's firm to be filled out of the firm's inventory. This allows the broker's firm to make money on the "spread" or difference between the purchase price and sale price." 

Exchanges need to pay rebates to market makers, and it's OK for an exchange to pay for order flow.  If a broker is paying another broker for order flow, the broker receiving the payment is a net tax on the system.  

My suggestion(s) are slightly different than you might expect.  Knight doesn't want to deal with the customer service side of running a traditional brokerage.  Managing accounts, fielding calls, and other customer support issues take manpower, and they don't want to deal with that.  My first suggestion would be to have Knight or someone like them, who theoretically could take the order and improve their market making efforts, and subsequently add more liquidity to exchanges, provide an execution platform for retail investors.  I doubt they would charge much if anything for a customer's order if they're willing to pay another broker for that order.  The key is, can they do it without operating in a dark-pool?

My next suggestion may be my next start up, so let's keep this on the DL.  For a customer who doesn't want to talk on the phone, doesn't need help, and just wants to send an order to the market, a simple execution platform that would send an order straight to the market could be done very inexpensively.  It could be done by an exchange, like you said.  It could even be done by your bank or credit card company.  

The execution or orders can be done separately from the brokerage responsibilities.  Account management is already done fairly well by banks like Chase, so that part of the business is just taken out of the equation. By using a unique identifier (like the tag 50 used in FIX) a simple trade execution platform could be set up at a very low cost.  The order would be sent to the exchange with the unique user ID and the brokerage account where the position will ultimately be housed.

If one broker is willing to pay for order flow, why is the other broker collecting a $10 commission?  What value are they providing?  

The purpose of a broker is to connect buyers and sellers.  

The purpose of an exchange is to connect buyers and sellers.  

In that light, one of the two isn't adding value.  As I suggested earlier while talking about Knight, there is value in the account maintenance and customer services provided by brokers.  That sort of account maintenance could easily be managed by your bank.   

Tradier Brokerage is working to take commissions as low as possible.  For full disclosure, AlgoFast routs orders to Tradier, so I'm biased.  Robinhood is another brokerage that wants to take commissions to zero based on the pay for order flow model.  I would shoot for zero commission, and I wouldn't stop with the pay for order flow model.  I would use advertising revenue to fund at least part of the company.  
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