In his book ‘Flash Boys’, Michael Lewis attempts to answer the question — what happens to my trade once I hit ‘execute’ now that high frequency trading firms are in the market?’
Here’s one answer — your broker sells you trade to a high frequency trading firm in a bundle with a bunch of other trades.
At that point they’re just orders. The high frequency trading firm that buys this bundle pays your broker a lot of money for the privilege of executing your order and turning it into a trade.
This practice is called ‘payment for order flow’, and it’s not new to the market. Bernie Madoff used to do it by paying other brokers a penny per share. Then his firm would use that to trade with a better understanding price. (This part of his business was totally different than the Ponzi scheme)
Think about it: If you know demand in the market, and you know when/how other people (i.e. the orders you just bought) are trading, you can trade smarter and better for yourself — sometimes by sacrificing the best price for the order you bought.
In our HFT world, payment for order flow has a new incarnation that HFT critics have been railing about for years.
Now it looks like regulators are going to start looking into the practice. Because of that, says the Wall Street Journal, stocks like Charles Schwab, TD Ameritrade, and E*Trade got killed last week. E*Trade fell 10%, Schwab fell 5%, and TD Ameritrade fell 9.2%.
One look at Charles Schwab’s 2013 annual report and you can see why the bears came out in full force on this news. In 2012 the brokerage took in $US236 million from “other revenue” sources. One of the sources was payment for order flow.
From the report:
Other revenue — net decreased by $US20 million, or 8%, in 2013 compared to 2012 primarily due to a non-recurring gain of $US70 million relating to a confidential resolution of a vendor dispute in the second quarter of 2012 and realised gains of $US35 million from the sales of securities available for sale in 2012, partially offset by an increase in order flow revenue that Schwab began receiving in November 2012.
Other revenue — net increased by $US96 million, or 60%, in 2012 compared to 2011 primarily due to a non-recurring gain of $US70 million relating to a confidential resolution of a vendor dispute mentioned above. In November 2012, the Company began receiving additional order flow rebates from market venues to which client orders are routed for execution. Order flow revenue increased by $US23 million due to this revenue and the inclusion of a full year of optionsXpress’ order flow revenue.
Charles Schwab told the WSJ that payment for order flow is “entirely different from the unfair access and practices used by high-frequency trading outfits that put investors at a disadvantage.”
It also released a note calling for the end of HFT saying that “traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets.”
Yet at the same time, payment for order flow gives HFT firms the ammo they need to do everything that they do.