Katya Malinova PRO
I am an Associate Professor, Mackenzie Investments Chair in Evidence-Based Investment Management at the DeGroote School of Business, McMaster University, Canada.
Siphoned Apart: A Portfolio Perspective on Order Flow Fragmentation
Markus Baldauf, Joshua Mollner & Bart Zhou Yueshen
Discussion by Katya Malinova
DeGroote School of Business
McMaster University
SAFE 2022
Frankfurt, Sept 28 2022
Payment for order flow: not new ...
- PFOF/off-exchange siphoning of retail is Not Great (for liquidity and uninformed):
- E.g., Easley, Kiefer, and O’Hara 1996
- Bessembinder and Kaufman 1997
- Comerton-Forde, Malinova, Park 2018
- Hu and Murphy, 2022
-
No Harm:
- e.g., Battalio, 1997
- Battalio, Greene,and Jennings, 1997
- The SEC’s 1997 “Report on the Practice of Preferencing”
Payment for order flow: does not grow old ...
-
Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit; 2020 settlement:
- "failed to seek to obtain the best reasonably available terms when executing customers’ orders, causing customers to lose tens of millions of dollars"
- "sold order flow to the market maker that gave it the best rebate rather than the one that offered the best price."
Payment for order flow: remains controversial
- June 8 2022, SEC Chair Gary Gensler:
-
-
"Payment for order flow can raise real issues around conflicts of interest. [...] distort routing decisions [...] incentivize broker-dealers to use gamification [...]
-
The European Union is actively considering banning payment for order flow, [...] joining [...] the United Kingdom, Canada, and Australia. [...]
-
I’ve asked staff to make recommendations"
-
- Bloomberg Sept 22, 2022:
- Sources: "The SEC will stop short of banning payment for order flow, a controversial way to process retail stock trades."
- But not without the "buts" ...
Payment for order flow
-
Traditional view on issues:
- siphoning the "dumb" flow off-exchange
- high on-exchange transition costs
- → is price improvement on high costs actually an improvement?
-
SEC "most recently voiced" concerns:
- tradeoff: PFOF vs. price improvement for customers
-
Echoed in Ernst and Spatt (2022) for options!
- DMMs that pay offer worse terms for retail
- add'l concern: "push" of retail to options trading (?)
- For more on internalization practices in options, stay tuned for Hendershott, Khan, and Riordan (2022) @ the 15:40 session!
This paper: cool new perspective!
- Zoom onto market makers/internalizers and their quotes
- MM can trade
- against only retail, or
- against all (on an exchange)
- MM can trade
- No brokers; no payments/fees/rebates
- no conflicts of interest/routing conflicts
- No asymmetric information
- Instead:
- Retail and institutions may trade in different directions
- → retail orders help "diversify"/"hedge" against the institutional orders
- Instead:
Comment #1: Sheep vs. Wolves?
Define a sheep?
Comment #1: Retail vs. Institutional
- Retail = traders that can use PFOF (& an exchange)
-
Institutional = can only trade on an exchange
- No other ex ante distinction (?)
- → The MM don't care which orders to buy vs. trade on an exchange
- Buy retail by design only, not b/c of specific characteristics.
- Can you imagine a market where institutional orders are bought instead?
Comment #1: Retail vs. Institutional
- Why the choice to define traders by venue access?
- almost makes retail "more sophisticated" ...
-
Ideally:
- retail flow characteristics
- institutional flow characteristics
- which flow (if any) would be bought?
Comment #1: Retail vs. Institutional
- At the very least, take a stronger stand?
- What do we know about
- correlation b/n retail vs institutional?
- sizes?
- MM sector?
- other parameters?
→ sharper predictions?!
Comment #1.2: want to know more about the true parameters!
Comment #1.2: want to know more about the true parameters!
Comment #2: would there ever be "internalize some" eq?
- "Internalize some but not all" arises only when the spreads are exactly equal
- Would this be a knife-edge case even if existed?
- Does the no brokers/fees/commissions/conflicts assumption bias towards the "internalize all or none"?
- All that asked, empirical evidence is for "internalize all"!
- Battalio, Corwin, Jennings (2016 JF)
Comment #3: key differences to the info-based models?
- Different trading motives, yet similar tradeoffs for MM
- Retail offset the costs of trading against one-dimensional flow
- A tad challenging to understand all the model parameters but PFOF arises, e.g.
- institutional = small children of a large parent order
- retail: random noise (buy and sell)
- → similar order flow as with info!
- Also: "Informed" is stylized
- A large order → price impact & a trader knows this
- →they are arguably informed ...
Comment #3: key differences to the info-based models?
- Results that are different to info-based models arise
- when institutional & retail flows are negatively correlated
- possibly b/c of differences in model setup
- zero-profit pricing typical for info-based models (tractability?)
- here: market clearing
- inelastic demands of noise traders
- zero-profit pricing typical for info-based models (tractability?)
How to empirically identify which channel is key for the wholesalers' liquidity provision choices?
Comment #4: what's the take-home re: PFOF?
- If the rules surrounding the PFOF were to change, where would we see it?
- Conflicts of interest/routing?
- Hedging/diversification of market makers?
- Informed investor trading/price efficiency?
- Through which channel will a change in PFOF regulations have the highest impact?
- Put differently, what (if anything) should the regulators resolve?
Comment #5: random thoughts
- Nice model
- Applicable not just to equity markets ...
- MM ex ante liq provision choices (quantity to supply) fit well with decentralized swap exchanges/liquidity pools in crypto-markets (Uniswap, Sushiswap, Pancakeswap, etc)
- A cool new market institution ...
- liq providers choose how much to deposit into a liq pool
- exogenous pricing function
- liq providers do not compete but get pro rata allocations
@katyamalinova
malinovk@mcmaster.ca
slides.com/kmalinova
https://sites.google.com/site/katyamalinova/
Siphoned Apart: A Portfolio Perspective on Order Flow Fragmentation Markus Baldauf, Joshua Mollner & Bart Zhou Yueshen Discussion by Katya Malinova DeGroote School of Business McMaster University SAFE 2022 Frankfurt, Sept 28 2022
SAFE 2022 discussion
By Katya Malinova
SAFE 2022 discussion
SAFE 2022 Discussion
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