Notes On How Modern Financial Markets Work

Scope And Purpose Of This Post

This post has snippets/paraphrasings of articles that get into stuff like exchanges, wholesalers, market makers, dark pools, high frequency traders, and so on.  Bullet points in quotes are article quotes.   Bullet points not in quotes are paraphrases of the article, unless I say something like "I think"/"I believe"/"I guess", which will be my own analysis.

My post The Mechanics Of How Stock Prices Change has stuff explaining basic workings of exchanges, and has an appendix about how price improvement works.

Articles...

Patrick McKenzie of Stripe fame (and active on Twitter), "How Discount Brokerages Make Money"

• "Discount brokerages mostly don’t actually talk to stock exchanges; that’s a specialized, detail-oriented, extremely regulated, and hypercompetitive skill set whose market clearing price is literally lower than zero."
• Net Interest subsection...
• Discount brokerages make a lot of money by offering you a low interest rate on cash while earning a higher interest rate on that cash (via very-low-risk methods); the earnings from this interest differential is "net interest income".
• "57% of Schwab’s revenues are from net interest. The firm could literally give away every other service; discount the mutual fund fees to zero, do away with commissions, etc etc, and they would still be profitable...Schwab isn’t even the leader among discount brokerages in dependence on net interest. That would be E*TRADE, at about 67% of revenues. Interactive Brokers makes 49% and TD Ameritrade 51% in the segment."
• "if you think that Wall Street is soaking the US middle class, you should be monomanically focused on the interest spread between cash balances in brokerage accounts and high-interest bank accounts or money market funds...But instead people get mad about payment for order flow, because nobody writes books about Interest Rate Spreads Are Just Too Darn High."
• Commissions subsection
• "A name often mentioned by my acquaintances with respect to commissions is Robinhood, which decided to take the hundreds of millions of dollars that discount brokerages spend on ads every year and instead subsidize commissions straight to zero. This is both bold, disruptive innovation and also just an incremental extension of a pricing war which the larger brokerages have been engaged in for decades."
• "The contribution to revenue across the discount brokerages is minimal: 6.8% at Schwab, 28% at TD Ameritrade, and 17% at E*TRADE...Interactive Brokers is the one standout, largely because it caters to high-volume professional and semi-professional traders; it makes 49% of revenues on commissions."
• He mentions "In addition to routinely shaving a buck or two off their list prices, Schwab is experimenting with zeroing commissions on their own ETFs" but there is a lot more zero commission stuff going on than this comment would indicate.  Fidelity, Vanguard, E*TRADE, and TD Ameritrade offer many ETFs with no commission.  My opinion: zero commissions on certain ETFs is not an experiment and I found it odd that Schwab was given such special treatment.
• TODO: more extracts

Matt Levine at Bloomberg, "Tesla Will Try To Be More Normal", Section "Order Flow"

• Wholesalers/liquidity-providers (/market-makers?) pay retail brokers (like Fidelity) for order flow from retail investors (buy and sell orders from people like you, me, your dentist).  Liquidity-providers love retail order flow because it is uninformed and random, as in your dentist is unlikely to do a buy order on something right before a huge institution is about to buy the same thing and move the price up, thus causing your liquidity-provider to lose money.  The wholesaler/liquidity-provider can do price improvement on retail order flow, so usually this Wholesaler-RetailBroker-RetailCustomer arrangement is win-win-win.
• Let's call this practice MMPFROF (Market Makers Paying For Retail Order Flow).
• The article also covers a wholesaler tactic that is not good for retail customers placing large orders.  This tactic is rare and Credit Suisse settled with the SEC for $10M because they used the tactic, so probably this tactic will not be used against you.
• A retail customer places an order that is big enough to go through multiple price levels on current exchange book.  Our example is for a buy order.
• The wholesaler quickly buys many shares, going through some ask-price levels, then directly sells you the remaining shares at a price better than the NBBO but worse than when things started.
• The share ask-price reverts somewhat to what it was before the large order, and the wholesaler buys shares at a price lower than what it sold to you.
• I guess the better way to execute a large order is to space it out, but I can imagine things being murky on the best way to do that.

Matt Levine at Bloomberg, "Carl Icahn Wants to Fight Dell Again", Section "Robinhood"

• The section contains another go at explaining how MMPFROF (market-makers paying retail brokers for retail order flow) is usually good for retail investors that these order flows belong to.
• The author goes over two objections to MMPFROF:
• "One [objection] is that it is bad for investors whose orders aren’t sold to market makers, the institutional investors who instead trade on public stock exchanges. Payment for order flow fragments the markets, takes retail order flow away from the public stock exchanges, widens out spreads on those exchanges, and, by segregating retail and institutional orders, makes institutional execution worse. This objection is probably true! If you’re a hedge-fund manager, you should dislike payment for order flow, because it makes public markets worse for you. (If you invest through mutual funds, as I do, you should also dislike it, for the same reason.) "
• My analysis: I find the idea quoted just above very interesting.  Perhaps I am helped (by market-makers paying for retail order flow) when I buy/sell an ETF, but perhaps my ETF holding is continuously hurt because the institutions that buy and sell the underlying stocks for that ETF are hurt by market fragmentation.  For buying/selling mutual funds, perhaps I am only hurt, since buying/selling the mutual fund is a direct book-value transaction with the mutual fund provider (neither helped nor hurt by MMPFROF), and then that mutual fund provider is hurt by MMPFROF.
• "The other objection is that payment for order flow is bad for investors whose orders are sold to market makers, the retail investors whose orders never touch the stock exchange. If the market makers are paying to get their orders, surely they are doing something nefarious with them, right? Otherwise why would they pay? This objection seems mostly wrong. Very occasionally there is some evidence of market makers doing naughty stuff [author links to that one Credit Suisse thing] with the retail orders that they buy, but for the most part, particularly for simple market orders, the result is straightforward: Retail customers are instantly able to buy stock at a price at least as good as, and usually better than, the best price available in the public markets. And the market makers pay their brokers for the privilege, so the brokers can offer cheaper (even free!) stock trades. They are unambiguously better off than they would be if their brokers didn’t sell their orders."

John D Arnold at Bloomberg, "Spoofers Keep Markets Honest"

• Note: there is a javascript on that page that obscures most of the article text.
• You can right-click on the page and select "view page source".
• You can enable webdev tools, inspect the last visible paragraph, and delete the 'style="display:none"' attributes to make the remaining paragraphs visible.
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• If you have a browser add-on like uBlock Origin, you can add a filter to block window._fence (the script that obscures the article text).
• "Overall, most strategies that rely on algorithmic trading, including those that use HFT, increase market efficiency -- and they often benefit the market by adding liquidity."
• But, the author doesn't like front-running and says it is overall bad for society/the-market.  Front-running example: some HFT guy suspects you're about to buy some particular thing, so the HFT guy buys the thing before you, raising the price a bit, and then sells to you at the higher price.
• Spoofing only affects and only hurts HFTers that try to do front-running.  Spoofing being legal decreases harmful-to-society front-running, and thus spoofing should be legal.

More Articles

• Matt Levine, "SEC Cuts Stock Exchanges’ Fees", first section talks a bit about exchanges, trading firms, data fees, and government-enforced monopolies.
• Matt Levine, "The 'Flash Boys' Exchange Is Still Controversial", talks a lot about IEX exchange application, high-frequency trading, institutional investors, market structure
• law360.com people, "A Deep Dive Into The CDS And Syndicated Financing Markets", talks about Credit Default Swap (CDS) stuff, including auctions.
• Matt Levine, "Why Exchanges Like Speed Bumps".
• Matt Levine, "Why Do High-Frequency Traders Cancel So Many Orders?". 
• Matt Levine, "Barclays Took a Last Look at Its FX Trades".