One of the reasons I started this blog in 2010 was because I thought that the general public was pretty misinformed when it came to how markets worked. Specifically regulated public markets. However, as I got into it, I found people were really misinformed as to how any market worked.
Markets are hard. They have to be nurtured. Sticky ones have automatic incentives for people to act built in. They solve problems. They allocate capital better than any centrally planned mechanism.
Recently, the ICE ($ICE) bought the NYSE ($NYX). A lot of regulators and wonks were worried about concentration of market power under one roof. I never worried about that. But one thing I have worried about is how our national stock markets operate.
CEO Jeff Sprecher of ICE is worried about some of the same things. This is from Dan Collins article in Futures Magazine.
A new sheriff is coming to the world of cash equities and options and he is determined to change the way those markets trade. ICE Chairman and CEO Jeff Sprecher dropped a bomb during last week’s Sandler Global Exchange & Brokerage Conference in talking about the new markets he is acquiring with ICE’s acquisition of NYSE Euronext. The conference was hosted by investment banking firm Sandler O’Neill + Partners.
He was referring to the cash equity and options worlds ICE will be entering with its acquisition of NYSE Euronext that participates in payment for order flow and internalization. “I have been very outspoken that I don’t believe you should pay for order flow,” Sprecher said. “When people talk about innovation and all they are really talking about is price cutting or front running, that is ridiculous. I am going to be very outspoken about trying to change elements particularly of the U.S. cash equities markets and I am being outspoken because with NYSE I think we should change them.”
Payment for order flow has been a bane of the equity and equity options world for more than a decade. It is widely disliked by the competing options exchanges but all have appeared afraid to act unilaterally for fear of losing market share. Sprecher does not appear afraid.
“I don’t care about market share. I will probably lose market share,” he told the attendees of the conference in response to a question from Sandler Principal Rich Repetto. “I don’t think you can do what I suggested without losing a lot of market share. What I hope is, we lose all the market share that is actually losing shareholder value. We want to give the market share where we are losing money back to the competitors. I will welcome them to take money losing business off of our books.”
Ever since I started this blog, one of the industry standards I have railed against has been payment for order flow (PFOF) and internalization. This a a huge development when the CEO of one of the largest stock markets in the world says the same. Other SEC regulated exchange CEO’s ought to do the same, but they have been silent.
Sprecher also took a Jeff Bezos like stance when it comes to market share. In the short run, he might lose. But, my bet is if the NYSE and their attached equity options lose the infernal unfair practice of PFOF and internalization, they will win the long run. They will have flatter, more competitive markets.
He is doing the right thing by educating his shareholders and being transparent about expectations. This isn’t “innovation”-but it’s great management. Sprecher is leading. That’s what CEO’s are supposed to do. As CEO of the nations most visible stock exchange, he has a responsibility to the marketplace that is higher than most others. Someone ought to write a business school case about how to manage the expectations of shareholders, because Sprecher knows how to speak directly to them.
Internalization and PFOF make retail customers third class citizens when it comes to making a profit in the stock market. All the SEC did when they authorized those practices was legalize front running for the big guys. Long term those practices along with others have undermined confidence in the national capital markets. That’s bad for markets, and bad for our culture as a nation.
In case you don’t know what they are I will give you a short definition right here.
Payment for order flow is when a big hedge fund or bank pays a discount retail broker to get a first look at your order. Customer is hoodwinked because they are paying “less in commission”, but their all in cost of trade is higher at order entry and exit. Big Hedge fund/bank uses the order to get out of their position-or takes it into their dark pool to engage in risk free arbitrage. They make pennies on the retail order. But, they do it billions of times a year. Technology is so advanced today that if this layer was eliminated, along with other operational market reforms customers all in cost of trade would be cheaper without PFOF.
Internalization is a similar practice. Big banks have proprietary trading desks. They take the orders that come to them from pension funds, retail customers etc and try and use them to trade against for profit. In the futures market, this practice is outlawed-it’s called bucketing trades. Internalization also allows big players to front run big orders and make money off of them.
These practices change the risk profile of the marketplace, and change the economic incentives of trading. I applaud Jeff Sprecher for shining a light on them, and trying to eliminate them. Every market participant ought to compete on the bid/ask spread. They shouldn’t be competing over operations and regulation.
Every exchange ought to compete on who can provide the most efficient marketplace to trade. They shouldn’t be bucket shops for big players to run over retail and other customers. By definition, the best marketplaces are highly distributed and enable everyone to have an equal opportunity to compete. That’s not been the case in stock markets. Technology should make things more transparent. It hasn’t.
We have made some tremendous technological innovations in the past thirty years. None of them have really eliminated layers of distribution and put retail customers closer to the product at any of the exchanges. Ending payment for order flow and internalization is a start. Tip of the iceberg. Let’s melt it.