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