Payment for order flow

dinn13 said:
On the other hand if you are on IB Lite then you'll get filled at a better price than the best offer
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My understanding was the improvement with PFOF is some trivial amount if any. Why would they give a better price when they could just pocket the difference? Of course as you mentioned you'd still have to compare that to improvement from midpoint/hidden orders and dark pools.

I think it's important to consider the second order effects of PFOF. The overall effect of shifting uninformed flow off the exchanges and leaving increasingly toxic flow is to widen posted spreads and lower size, which then allows PFOF firms to provide worse fills as well.

So even if on an individual basis it makes sense for a retail trader to use PFOF, they might still be better off if PFOF was banned. Anecdotally, there are certain smaller stocks that trade almost entirely off exchange. They have huge spreads and I've found it pretty much impossible to get a fill without crossing the spread, compared to other stocks of similar volume but with a larger fraction of trades occurring on the exchanges.

It seems like allowing sub-penny quotes for liquid stocks would kill any advantage PFOF might have there, although that would need to be coupled with reforms to maker/taker rebates or NMS protections.
 
qlai said:
Why would they need to take the other side of such flow when they can simply latency arb it against SIP? Since, as you mentioned, HFTs can identify which customer's flow is toxic then should not be a problem to them - worst case they can simply pass through. So I guess my question is - why is it not enough to know that order is allowed to be delayed up to N milliseconds to make money on it (or at least not loose any)?
Edit: is it because they are paying for it, so need to at least cover costs?
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A latency arb or other short term opportunity doesn't always exist so simply immediately dumping the risk is a no go. HFT would love to exit positions immediately but there is a tcost to it. So for example one of the reasons Virtu carries over 3 B overnight https://whalewisdom.com/filer/virtu-financial-llc Pretty much every HFT firm now carries risk overnight (or at least to the close) even if not explicitly modelling overnight returns because exiting every position is often too costly. The risk is hedged to varying degrees by different firms though and some of them basically consider hedging the risk as exiting position but they still have the positions on the book.

On lit exchanges and dark pools they don't know a priori that any fill they'll get is not toxic or that there isn't a ton of size coming behind it. So when adding liquidity the game they play is to make a short term prediction (consume a ton of data, tons of work to model it, although some just test in prod and don't have backtests) and then quote in that direction and try to get the best position in the book. But as soon as that short term prediction changes they then cancel the order to get out of the way of potentially toxic flow. Now that is a rather complicated and costly game due to the low latency requirements and they're playing with sharks since other HFT wants to pick off each others potentially stale quotes relative to a short term prediction/fair value.

Also of note, the short term prediction is effectively the probability that toxic flow won't come hit your order / is going to go the opposite way. In other words if sitting on the bid they're making the bet that it's more likely toxic flow will hit the ask and not their order. But it's no guarantee. At anytime an asset manager could come in and sweep the book while working at a high % of adv and be extremely toxic to them. It's a hard game to play.

So having a line coming from etrade in which they know the flow is on average not toxic without having to add/cancel orders constantly makes for easy money. In some sense they are paying to be top of the queue since that set of orders goes directly to them and they are guaranteed a fill. I'm guessing they also try to build alphas and game the flow to some degree but don't know that for sure. In which case knowing where all the fills are coming from would be very helpful (ie they would know it's retail flow as opposed to getting a fill on nasdaq where who knows who it was).

It's not enough to know that the order is slow or delayed because whoever it is could be part of a much larger flow that is toxic regardless of speed. I assume no one from etrade is trading 10% of adv on a liquid name while that is rather common with an asset manager who is slow. They'll likely take the other side of retail flow any day but don't want to be on the other side of an asset manager that is about to move the price 3%, they actually want to trade in the same direction as the asset manager...
 
elt894 said:
My understanding was the improvement with PFOF is some trivial amount if any. Why would they give a better price when they could just pocket the difference? Of course as you mentioned you'd still have to compare that to improvement from midpoint/hidden orders and dark pools.

I think it's important to consider the second order effects of PFOF. The overall effect of shifting uninformed flow off the exchanges and leaving increasingly toxic flow is to widen posted spreads and lower size, which then allows PFOF firms to provide worse fills as well.

So even if on an individual basis it makes sense for a retail trader to use PFOF, they might still be better off if PFOF was banned. Anecdotally, there are certain smaller stocks that trade almost entirely off exchange. They have huge spreads and I've found it pretty much impossible to get a fill without crossing the spread, compared to other stocks of similar volume but with a larger fraction of trades occurring on the exchanges.

It seems like allowing sub-penny quotes for liquid stocks would kill any advantage PFOF might have there, although that would need to be coupled with reforms to maker/taker rebates or NMS protections.
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The price improvement is a relatively trivial amount. The reason they do is so that they can claim the order received best execution since the filled price is better than the far take. I forget but is there also a rule that they can't just fill at the far take, that they have to price improve? I vaguely recall something like that but could be totally wrong.

And I agree. All the internalization is making the lit markets extremely toxic and thinner so easier to manipulate. Although I don't think PFOF is that big a deal from that perspective since it's a relatively small part of the market (I've seen some numbers that might just be ~5% of the market). A larger part of the market are asset managers that are also internalizing flow at dark pools and what not although not part of PFOF and that's definitely a significant issue.

I primarily don't like PFOF cause it kinda bothers me that they get some relatively easy money...
 
dinn13 said:
I'm guessing they also try to build alphas and game the flow to some degree but don't know that for sure.
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I don't know for sure, but it would make a lot of sense :) So as far as I'm concerned, U.S equity markets for retail traders are essentially CFDs run by select HFTs.
 
qaz said:
I will need to point out that active traders will lose out the most just like how a wallet has a small hole and coins drop out ever so often. I believe ET is populated with active traders.

For the crowd that buy and hold for months or years, there's minimal impact.
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%%
That;
+ generally true. And since most [stock ETFs, mutual funds] millionaires are made by investing/long term investing; some traders are millionaires. IBD founder did both-not a predicition
 
qlai said:
I don't know for sure, but it would make a lot of sense :) So as far as I'm concerned, U.S equity markets for retail traders are essentially CFDs run by select HFTs.
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I was looking to connect to one of the SLP's directly from an HFT firm cause they were pitching it. I directly asked them if they build alphas off of the flow and they claimed they don't. But were putting a caveat on it and being a bit cagey which gave me the impression they were full of shit. I'm pretty sure it isn't illegal to do that and since there would be no way for me to verify they aren't doing it.. I'm guessing they do. They also said if my markouts looked bad they would cut off the flow so I didn't bother connecting.

and I think you're basically right as far as retail via PFOF basically trading via CFD.. haha.. good observation
 
Lets talk about options where the average spread is wider than stocks.

When there is market efficiency the spreads are tighter. When the spreads are tighter, the likelihood of finding hidden liquidity is higher than one with a wide spread. Who benefits from a wider-spread? The market maker. Of course the counterparty gets screwed.

Brokers that are selling PFOF are essentially giving up their customer's right to find hidden liquidity and that is perfectly legal as the PFOF buyer just has to guarantee NBBO.

Introducing a maximum spread is akin to forcing an artificial market efficiency. The MM will demand to be paid for undertaking that risk (especially in volatile periods) and that cost will have to go somewhere; I bet you know where. The solution is simple. Get rid of PFOF and let the trading volume all flow to the exchanges, more volume=more liquidity=tighter spreads=higher possibility of finding hidden liquidity, and it doesn't cost anything. The only loser will be PFOF firms and the financial market will be liberated from a bug in its body.
 
qaz said:
Lets talk about options where the average spread is wider than stocks.
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Is there PFOF in options? Is there hidden liquidity in options? I'm not familiar, but I think very different from US equities.
 
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