Stop this game
Here are some basic facts:
Retail flow, in aggregate, in the long run, loses money, not because retail flow is "misinformed" but because retail flow is "random" and loses exactly the sum of spread and commissions.
Retail flow is useful to the trading process to the extent that fundamental investors are able to interact with this liquidity, at least some of these losses on retail side propagate back into their 401(k)'s.
This connection between retail flow and fundamental investors is completely broken in the U.S., as losses of retail are fully offset by gains of wholesale market makers.
"PFOF" is horrible because it creates incentives for retail brokers to ensure trading through their platform is as uninformed as possible to maximize how "valuable" flow is to the market makers. There is a reason why Robinhood flow historically attracted the highest PFOF.
"Free trading" is a silly gimmick which just turns transparent costs into opaque ones, and incentivizes more noisy trading to the benefit of retail brokers and wholesale market makers.
"Gamification" of a valuable function of asset pricing and capital allocation is even more disruptive to true price discovery and capital formation.
"Price improvement" vs market that is artificially wide due to badly broken market structure is just disingenuous marketing. The way to get actual price improvement is to put retail flow on exchange where multiple trading firms and institutional investors and other retail orders would compete for it.
What are the solutions then?
1. Force all retail flow on exchange, to allow it to interact with other retail and institutional flow
2. Remove the notion of quote protection. It is an extremely ineffective tool to prevent tradethroughs, and stifles innovation, while promoting market fragmentation
3. Allow exchanges to charge whatever they want for trading, mostly to move away from nonsensical "cents per share" pricing
4. Ban any kind of rebates or PFOF. Force exchanges to compete on innovative market models, not on minuscule price differences. Put pressure on excessive fragmentation of lit liquidity which costs investors billions
5. Introduce FTT of 10 bps for all trades. Taxing distortive and irrational activity means more money for more productive things in the economy and less distortive and irrational activity. Volume will decrease, but volume is not the same as liquidity, U.S. market does really well on the former, but not the latter.
6. Redesign minimum price increments, MIFID II style, to allow tick sizes to change as a function of liquidity and price level. Currently a lot of stocks have either artificially wide spread allowing for excess profits to market makers, while other stocks have spreads of hundreds of ticks, completely killing liquidity on top of book
I will take the other side of this one: 1 The trading in GME is anything but 'random'. This was a very organized short squeeze 2 All the handwringing about margin requirements did not appear when Akshay Naheta did this for Softbank. Do not recall any $4bn margin calls. Or when the market crashed. If DTCC had dared ask for 500bn in margin in March 2020 because the VIX was at 80, the Treasury and Fed would have ripped their heads off. 3 The trouble with market making is a small slip can wipe you out, if anyone recalls Knight Trading, which lost $400mm in forty minutes and were bought out by er, Citadel. Now that we have established this is a casino where the house can lose half a billion a day, you need somebody with 5bn lying around as table stakes. Those capable of showing up will charge the rent they please. 4 This is a letter to regulators. Except, 1 tells you there is no widow or orphan to protect here. The people who trade at WallStreetBets understand philosophically and practically exactly what they are up to. There is a wide distribution of gains and losses, but they are not entitled to cry foul later and they know it. 5 What were the people who were short 4x the issued shares thinking?
Research at AlphaSense
4 年Average retail investors do really poorly vs. almost any passive asset class. See the 20 year data from JPM Asset Management on slide 74 here https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/guide-to-the-markets/mi-guide-to-the-markets-us.pdf
Founding Partner at Babelfish Analytics, Inc.
4 年Something that isn’t discussed is the cost to institutional investors caused by PFOF. We are about to release something that shows there is a fairly significant cost to mutual funds / hedge funds as a direct result of PFOF. If we accept the assertion that retail has never had it better, we have to accept that Robinhood (and yes others) are retail and mutual /hedge funds are not - which is flawed logic. Robinhood customers are enriched to the detriment of pension funds and other mutual/hedge fund clients. The genius of the PFOF argument has been the framing that retail only includes people with Robinhood and Schwab type brokerage accounts, where that argument couldn’t be farther from the truth.
Co-Founder, Afterprime & Argamon Group.
4 年Alexander G. amazing insights, thank you so much for sharing. XTX is an amazing liquidity partner and our clients love the execution and pricing we receive from you. “PFOF” is horrible because it creates incentives for retail brokers to ensure trading through their platform is as uninformed as possible to maximize how “valuable” flow is to the market makers." Completely agree with this. As we know the vast majority of retail brokers profile losing clients into a b-book where they profit from client losses and are incentivized to bring on uninformed clients with the aim to capture as much of their deposit as possible. Would love to hear your opinion on the state of B-booking in the retail space? How would you see the industry improving? Our take is that brokers should be at least made to disclose to clients before they are switched from A book to B book (or vice versa) as their liquidity profile changes between books. This can have huge implications for certain strategies when they are suddenly trading into the real market without being notified.
Consultant - Engineering at Two Sigma
4 年Great post Alex