Saturday, 1 April 2017

Sub-pennies rule!

I'm not a fan of payment for order flow (PFOF).

Wholesalers pay for orders to be sent to them from Schwab, TD Ameritrade and their kin. Mainly the retail trade. After your trade executes, far from any public exchange, your retail share statement shows a price with a few extra decimal places even though you specified a round penny, like you have to. It is sometimes a puzzle as to what may be going on and how. It's pretty opaque. In the SEC we trust.

Similarly, discretionary or mid-point pegs, and some other dark orders may execute in sub-penny increments.

But, but, but, there is a rule against sub-penny pricing. What's going on? Let's meander a little bit through the twisty passage ways of the NMS maze.

The NMS Rule 612 "Minimum Pricing Increment" disallows sub-penny pricing for stocks above a buck. This was justified at the time so "meaningless" price improvement would not be used to step in front of prices and gain priority. I'm not sure about you, but I can imagine a lot of times that someone may think a half a penny extra on their trades would be nice. Are sub-pennies really that meaningless?

Here is a FAQ from the SEC on Rule 612 which goes through some particulars and exceptions. There are a few exceptions to the sub-penny rule. For example, you can use a performance target on an order, such as VWAP, with sub-penny "targeting." Question 13 in the FAQ handles the sub-penny price improvement scenario for market centres:
"Question 13: May a market center provide sub-penny price improvement, compared to the NBBO, in an NMS stock for which sub-penny quotations are prohibited by the Rule?
Answer: Yes, provided that the execution does not result from an order, quotation, or indication of interest that was itself priced in an impermissible sub-penny increment. <snip>" 
Sub-penny trades are OK.

Do those pennies matter? Are spreads really that tight? I just took a snapshot of the active stocks trading on BATS today:
(click to enlarge)
The spreads on all the stocks are a single penny wide. You may have to click to enlarge the image to see them properly. Penny spreads are not universal, but they are common as you can see. We've come a long way from quarters, eighths, and nickels.

Now, think about venues or systems offering sub-penny pricing. You have to ask yourself is it fair that PFOF and dark orders can jump the priority queue with sub-penny increments when regular stuff can't? Aren't public exchanges' displayed orders being disadvantaged?


Let's meander around PFOF a little.

PFOF is an essential piece of the NMS and retail would be worse off if it was eliminated today. Orders are price improved and thus are better than the best that could be achieved by hitting the National Best Bid or Offer. Those sub-pennies give customers better prices.

PFOF is a blight on the NMS as it represents an abrogation of a broker's duty to, you know, do their job: broke. A broker has an obligation to best execution on behalf of their clients. How is it such that they can sell your order to a third party, get a fill back, and pocket that little payment bonus? The obvious thought would be: what if the broker could pull their finger out and execute just as well as the third party, and provide you with the benefits of the fee they didn't have to pay, and give you the benefit that would otherwise accrue to the PFOF firm. Wholesalers are not a charity. Why should they make money off you? It would seem you should be able to do better by keeping it all in house, right?

Perhaps not. Executing transactions well is complex and expensive. Smaller brokers are disadvantaged, especially in term of technology, and outsourcing is perhaps reasonable there. Also, the sub-penny availability for price improvement means that an internaliser has a great deal of opportunity to take advantage of two sided flow and share the benefits between the broker (fees), wholesaler (spread), and customer (sub-penny price improvement). If your order, God forbid, went to a transparent, fair, efficient, public market, you'd have to trade at a penny price and get a worse fill!

That is, the ability to trade in sub-pennies discourages trading on public market. Transparency is harmed. Price discovery and efficiency is also, arguably, harmed.

That is a real conundrum. The customer is better off, but the market structure is poorer for it.

Dark, parasitic orders

We get to the same conclusion if we think about dark orders, such as types of mid-point peg, in a similar way. They are parasitic and rely on the efficiency of the surrounding market. They don't contribute to price discovery. However, you may get a price improvement that beats crossing the spread. It seems wrong to me that a publicly posted price can't compete with such prices that dance around in the dark.

One way of looking at sub-pennies is that they destroy markets. They discourage posting of public prices. Transparency and price discovery is harmed.

A good example of this phenomenon can be found at IEX. Let's have a look at a BATS execution quality report for one of the stocks referred to above, AMD:

(click to enlarge)
You'll see the "Effective Spread" is $0.00429 at IEX. It seems a lot better than the other exchanges. The reality is that this table is not comparing like with like. IEX is mainly a dark exchange with only around 20% of volume sent there actually being lit volume. A good deal of the volume in that table is dark for IEX. I checked that by adding up the "eligible shares" volume for enough symbols to get to a point where the total eligible share exceeded the IEX lit volume traded but it is not immediately clear what exact criteria is used for the eligible shares, but some of the table's IEX volume is dark. You must also not forget that IEX's dark fees are excessively high at 9 mills on both sides.

For what it's worth, here is how the BATS do the "Effective Spread" calculation in their table:

Here is the strange way that BATS counts eligible shares in them there numbery things:

Yes, you read that right, trades above the NBBO mid-point are considered buys. Put that in your price improvement formula and smoke it think about the corresponding seller who didn't just get a price improvement.

The other exchanges are mainly lit, so the comparison is not really an accurate one. It's a bit silly that a bid filled at best is penalised by such mid-point effective spread formulae. The price improvement is also kind of problematic. IEX's statistics are especially fraught when you consider the timing of fills and the likelihood of IEX's quote instability factor preventing trades from actually occurring at that most important time to trade, when the price is changing! "Lies, Damned Lies, and Statistics."

I'm not fond of parasitic dark trading like that which IEX expensively provides. I feel that even though it is certainly useful, it should be consigned to the dark pools where it belongs. Public exchanges should be about transparency, efficiency, and price discovery which are all things IEX's performance, sadly, does not encourage. Hopefully the SEC will see the mistake it has made and fix NMS one day. Until then, the SEC will likely have to allow NYSE's speed-bump, and perhaps others, to extend the fiasco that is the hall of mirrors. At least NYSE's mid point speed-bumped clone is likely to put IEX's current approach out of business due to a more sensible fee structure.

Sub-penny pricing needs to be encouraged

I think the answer is obvious. If you want better executions in a transparent market place that encourages efficiency, you have to support some degree of sub-penny pricing. Just how to do that is an interesting and big question to ponder.

I'm not fond of PFOF, but it is delivering results despite it being a weird perversion of best execution obligations. Whilst the public may want to kick out at those HFT wholesaling folk, they really are providing a beneficial service to Jane Doe on Main Street. The service goes beyond what the public market can provide thanks to the sub-penny rule limitations. That is, if you stopped PFOF immediately, the customers would be worse off, and it is quite likely the uneasily negotiated PFOF efficiency and benefit could not be regained under current NMS rules. Awkward, huh?

Also, I'm not fond of dark orders in public exchanges, however, just like those parasitic index funds, parasitic dark order types, such as mid-point pegs, do have some utility. I just happen to think that such orders have no place in public price discovery and should be relegated to the ATS / dark pool space. The SEC should be encouraging open, fair, efficient, and transparent price discovery in public markets.

Is it just me, or do you also find it weird that much of the efficiency of the market comes from working out how to go around the rules to avoid open and transparent pricing?

Despite the obvious profit motive, giving the market better prices is a critical but much criticised chore. Soul matters. Perhaps if you see someone from an HFT wholesaler in the street, such as Citadel or KCG, you might think about thanking them with a hug.

Just don't get arrested.

Happy trading,



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  2. How much time does the wholesaler get to execute the order from the retailer that received PFOF?

    1. It has changed over time. You can read, US microstructure - why the rules don't matter about the footnote to a regulatory note that required direct feeds, if you use them, to be used for best ex, including for PFOF. This was from Nov 2015.