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Comment by chollida1 | Hacker News Reader

> This is simply false. For example, IB describes the mechanism here

Well to be fair, i never mentioned IB, you did. I'm correct on this issue. Let's leave IB out of this as what you describe does happen but is a completely separate issue from selling order flow.

First off Schwab has already publicly admitted they sell their order flow. I've talked to 4 Canadian banks who do the same.

The internalizers who buy the flow are then allowed to either fill the order or pass it along, to the market, they get to see the order before it gets to the market, this is the free look i was talking about.

You may not be aware this happens but it does. I've literally talked to people on both sides of this who freely admit what they do. its currently legal, but I don't think it will be for much longer.

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Selling order flow refers to the exact mechanism IB just described. It's mechanically no different from a dark pool (such as IEX, the heroes in Flash Boys).

If you have evidence otherwise, by all means post documentation describing the specific mechanics of how matching works. Simply citing news articles that use the word "sell order flow" doesn't count.

I just cited IB because their docs are very detailed and because I know them well.

You two are talking about different things. They are similar but the mechanics are different. IB's example is an internalization pool where liquidity providers may post quotes and potentially fill within the NBBO when they have a desire to match/improve the quote.

The KCG and Citadel business is called wholesaling. A broker like Schwab has market orders or marketable limit orders from customers. They make an agreement with a wholesale market maker like Citadel to fill all of those orders up to a certain size possibly, within the NBBO, in exchange for a fee and some price improvement requirements.

So imagine you're Citadel. You have a stream of incoming orders that you commit to fill at the current market prices with a bit of improvement. If the order flow is small, you just sit on the delta waiting for flow in the other direction or trade out patiently on exchange to make a spread. If the flow becomes largely imbalanced, you can liquidate the delta aggressively on the public market to hedge at a very small cost. Say the NBBO is 100.50 bid 100.51 offer and you just sold 500 shares at 100.5099 and bought 2000 at 100.5001. You can dump the 1500 residual on the exchange bid or in dark pools, whatever, and all you lose is the price improvement you gave and fees, which are smaller than the spread you make on a "good" trade.

In effect, the wholesaler is cherry picking and getting a cheap option to make a spread. All the small retail trades that are easy to capture spread on get siphoned off the exchanges, and they're left with only the imbalanced toxic ones. This is good for the wholesaler, good for the retail trader (he gets a bit of price improvement and lower trading commission), bad for the exchanges, and bad for on-exchange market makers like most HFT firms.

It's arguably "fair" to price uninformed flows differently, it's very common in some markets like FX, but locking that up behind opaque pricing agreements where only a handful of firms participate isn't. Most market making firms would gladly compete to offer even more sub-penny price improvement to retail trades, and there are even a few exchange programs that tried to do this but never got much traction.

Every time I've looked into the mechanics of paying for order flow, it was just a pay-to-play dark pool with certain extra requirements (e.g. you must match X% of trades). Do you have documentation on a brokerage that provides some sort of "first peek" mechanics that might allow frontrunning?

I think we are in agreement that the main purpose of buying order flow is to price discriminate based on delta toxicity.

I am not saying the mechanics allow front-running. It is just different from a dark pool or exchange in that the wholesaler guarantees execution and has some discretion over how to provide it. It's not as if Schwab pings a bunch of internalizers to say "hey, can you fill this at the NBBO?" and then routes out themselves if nobody says yes. The wholesaler must fill the order whether they want it or not, and can either wear the delta, fill it from their own inventory, or execute in the market to facilitate the trade as riskless principal. The wholesaler gets contingent orders like stop market and stop limit orders and is responsible for executing them as well. It is more like having the retail broker outsource their execution similar to how a fund may have a bank desk execute orders on their behalf, except a bank desk usually has even more discretion over execution.

Hate to link to the Themis blog, but they cite the SEC here describing how internalizers, not retail brokerages, routed sell orders out to exchanges on May 6th: http://blog.themistrading.com/2010/10/the-internalizers-and-...

You seem pretty informed on this. I'm still an investing novice, but hoping you can give some insight here...

Does the practice described in this article and what you are discussing ultimately have a negative impact on Joe Investor who is taking the Bogleheads approach and sitting on several index funds, dollar-cost averaging his contributions, and occasionally rebalancing (but ultimately following a "buy and hold" approach)?

Could the outcome of this come back to hurt the Joe Investors of the world?

I'm not the person you asked, but since you invoked Bogle, you should know that Vanguard (a) uses wholesalers and (b) has publicly and repeatedly claimed that high-speed electronic market-makers have improved outcomes for their investors.

Thanks for the clarification Thomas. I'm still a bit fuzzy on the potential impact of wholesalers and such with regards to regular Joe '401k' Investor. I'd love to read more if there's any solid articles you're aware of that explain this.

As a regular investor who is making his way through "A Random Walk Down Wallstreet," it is hard to look at how Wallstreet has behaved over the years and not feel paranoid that I'm being taken advantage of at every turn. Right now I like the Bogleheads approach to investing, and the logic behind it, but am interested in how even that approach is potentially being taken advantage of, and what those real risks are to investors of that philosophy. Or...is that even something to be worth getting concerned over and is there a bigger threat I should be focused on learning about?

The people who get taken advantage of by Wall St. tend, strongly, to be active traders. It's been a long time since I read ARWDWS, but I feel like part of the thesis was "don't try to compete with Wall St.".

I'm assuming by "Joe 401k" you mean someone putting a chunk of their income into an index fund occasionally and keeping it there for the long haul. All of the innovations in the market are good for them without a doubt. Computers can price index ETFs perfectly vs. their constituents so you always get a fair price. Spreads and commissions have never been lower.

Wholesalers make things even better for the retail buy and hold guy by filling them inside the bid/ask spread. The kickbacks they pay to brokers mostly translate into very low brokerage fees. Now you can trade stocks for a few dollars at a penny spread but it was $50 or $100 in commission years ago, with spreads of eighths or quarters, which can really eat into your savings when you're investing a small amount.

The main things I'd say to be wary of are:

a.) Trying to compete with professional intraday traders. Even if you have a good feel for the market, someone faster and smarter is going to beat you to the punch most of the time. The markets are much, much tougher for day traders, and the complex structure makes it easier for sophisticated automated traders to take advantage of them. It's just a waste of time and money.

b.) Trading when the markets are in a crisis mode. Automated market makers don't have as much capital as the big banks did because there's simply less "juice" in the business, so they won't be there buying forever in a falling market. No market maker ever would, but when they were earning quarters instead of pennies, there was more incentive to take on risk because the market had a built-in edge. Computers also have a lot of safety logic that can make them leave the market due to bad data during extreme events. You should always set a reasonable limit price on your orders, avoid trading around volatile times like the open or economic releases, and avoid market stops or other order types that can make you trade in an illiquid market at the worst time.

c.) Putting your money into things that are either risky like individual "hot" companies where you're competing with the best hedge fund analysts or products that are inherently bad to buy and hold (leveraged ETFs, commodity/volatility ETFs often have time decay or lose money rolling futures).

This is really informative--thanks for breaking it down like this.

So if I'm largely a buy-and-hold kind of guy with my investments, there's not much to worry about from these practices then it sounds like. I do still worry what the risk is for buy-and-hold investors flocking to index funds as that seems like it is ripe for a problem of some sort, but given the nature of what an index fund is, I'm having trouble identifying how that could be a big issue.

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