Brokers sell ETF order flow used to trade against clients

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Rick Ferri
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Brokers sell ETF order flow used to trade against clients

Post by Rick Ferri » Sun Jul 15, 2018 4:23 pm

If you’re a ETF investor and want to read a book that will make your blood boil, read Flash Boys by Michael Lewis. It’s all about how HFT (high-frequency trading) is skimming money off your trades.

Here is how it works. Brokerage firms sell order flow to hedge funds and proprietary trading desks who in turn use the information to front run your trades and skim money off the top. This is how some investment firms can say your getting free ETF trading when really your not. As a former Schwab client, I never seem to get great ETF execution because they sold the trades to UBS, who in turn gave thier HFT customers first look.

The going rate that brokers get is 20 cents per 100 shares traded. That’s not a lot, but it’s before your trade is used by Virtu Financial, Citadel, and other third parties to make money from your trade.

Betterment and other Robo-advisers advertise no commission trading (M1 Financial, Wealthfront). They use APEX Clearing Corporation (APEX) to execute ETF trading. In turn, APEX sells the trades to a variety of HFT and others. So, if yours robo client, your trading really isn’t free, it’s just commission free.

All brokerage firms including APEX are required to prepared a report pursuant to a U.S. Securities and Exchange Commission to make available to the public quarterly reports about their order routing practices.

The report provides information on the routing of "non-directed orders" - any order that the customer has not specifically instructed to be routed to a particular venue for execution. For these non-directed orders, APEX has selected the execution venue on behalf of its customer and collects a fee.

Selling your order and the information that goes with it is legal as long as the process is generally disclosed. Realize brokerage firms are not fiduciaries so they don’t have to operate in your best interest. It’s OK for them to make money from your trades without you really understanding how it’s done or how much your giving up.

For the record, here is a link to APEX trading disclosure:

APEX Order Routing Disclosure and Report

Just so you know where you money is going...
Last edited by Rick Ferri on Sun Jul 15, 2018 4:35 pm, edited 2 times in total.
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Re: Brokers sell ETF order flow used to trade against clients

Post by SlowMovingInvestor » Sun Jul 15, 2018 4:33 pm

I did read and enjoy the book, but I'm not sure it's that applicable to buy and hold individual investors. The small extra spread that a buy and holder pays should be lost in the noise and for small purchases is probably less than a brokerage fee.

Also, some brokerages like Fidelity say that they route the order to the natiional best offer and price quote. Does that mean they don't really sell order flow unless the exchange/pool offering payment is also offering best price ?

I have heard that IB does not get paid for order flow.

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Re: Brokers sell ETF order flow used to trade against clients

Post by Rick Ferri » Sun Jul 15, 2018 4:39 pm

I agree it’s not a lot of money for a buy and hold investor, but is is disconcerting nonetheless. This stuff has remained hidden for years. What else don’t we know?

I’m not familiar with a Fidelity’s trading process and can’t comment.
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Re: Brokers sell ETF order flow used to trade against clients

Post by stlutz » Sun Jul 15, 2018 4:44 pm

This seems to be a helpful writeup on the subject: https://www.stockbrokers.com/guides/order-execution

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Re: Brokers sell ETF order flow used to trade against clients

Post by whodidntante » Sun Jul 15, 2018 4:48 pm

Not to worry, Dr. Asness says we benefit from HFT. :P
https://www.youtube.com/watch?v=y8dQrp9pCB8
Last edited by whodidntante on Sun Jul 15, 2018 5:15 pm, edited 1 time in total.

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Re: Brokers sell ETF order flow used to trade against clients

Post by Rick Ferri » Sun Jul 15, 2018 4:53 pm

stlutz wrote:
Sun Jul 15, 2018 4:44 pm
This seems to be a helpful writeup on the subject: https://www.stockbrokers.com/guides/order-execution
Good article. Thanks for sharing. There is information on which brokers take payments and which do not.

Using mutual funds instead of ETFs bypasses all of this. You buy and sell at NAV at the end of the day. Everyone gets the same price. No middlemen.
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Re: Brokers sell ETF order flow used to trade against clients

Post by livesoft » Sun Jul 15, 2018 4:55 pm

And don't forget to read Scott Patterson's Dark Pools which covers the same ground, but better and a couple years before Michael Lewis.
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Re: Brokers sell ETF order flow used to trade against clients

Post by drk » Sun Jul 15, 2018 5:07 pm

Rick Ferri wrote:
Sun Jul 15, 2018 4:53 pm
Using mutual funds instead of ETFs bypasses all of this. You buy and sell at NAV at the end of the day. Everyone gets the same price. No middlemen.
Not completely. You avoid middlemen on the ETF transaction, but the mutual fund's managers still work with brokers to execute trades. From the Vanguard 500 Statement of Additional Information (page B-47):
The advisor decides which securities to buy and sell on behalf of a Fund and then selects the brokers or dealers that will execute the trades on an agency basis or the dealers with whom the trades will be effected on a principal basis. For each trade, the advisor must select a broker-dealer that it believes will provide “best execution.” Best execution does not necessarily mean paying the lowest spread or commission rate available. In seeking best execution, the SEC has said that an advisor should consider the full range of a broker-dealer’s services. The factors considered by the advisor in seeking best execution include, but are not limited to, the broker-dealer’s execution capability, clearance and settlement services, commission rate, trading expertise, willingness and ability to commit capital, ability to provide anonymity, financial responsibility, reputation and integrity, responsiveness, access to underwritten offerings and secondary markets, and access to company management, as well as the value of any research provided by the broker-dealer. In assessing which broker-dealer can provide best execution for a particular trade, the advisor also may consider the timing and size of the order and available liquidity and current market conditions. Subject to applicable legal requirements, the advisor may select a broker based partly on brokerage or research services provided to the advisor and its clients, including the Funds. The advisor may cause the Fund to pay a higher commission than other brokers would charge if the advisor determines in good faith that the amount of the commission is reasonable in relation to the value of services provided. The advisor also may receive brokerage or research services from broker-dealers that are provided at no charge in recognition of the volume of trades directed to the broker. To the extent research services or products may be a factor in selecting brokers, services and products may include written research reports analyzing performance or securities, discussions with research analysts, meetings with corporate executives to obtain oral reports on company performance, market data, and other products and services that will assist the advisor in its investment decision-making process. The research services provided by brokers through which a Fund effects securities transactions may be used by the advisor in servicing all of its accounts, and some of the services may not be used by the advisor in connection with the Fund.
Those brokers also have substantial latitude when it comes to fulfilling orders.

Edited to add: here's a Money Stuff story about that from last year.

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Re: Brokers sell ETF order flow used to trade against clients

Post by ananthar » Sun Jul 15, 2018 5:21 pm

The sale of order flow typically has a small negative effect for small orders but a very large negative effect on large orders (such as typically executed by mutual funds). Even if you use a broker that does NOT sell order flow (or direct your orders to the largest exchange offering Best Bid/offer) your order is still negatively impacted by the fact that HFT's (and other so-called market makers) alone have the right to place limit orders in 0.01 cents/share increments, and hence can force the orders to be rerouted to their small venues since these temporarily become the Best Bid/Offer, and then the HFT's cancel their sub-penny quote (along with the any similar quotes on other venues) and then force a fill at the next best Bid/Offer (+ 0.01 cents/share). Worse yet this has been happening for so long now that all non-HFT limit order liquidity provided by retail traders has dried up (since most retail traders have figured out their limit orders will never get filled unless the market is moving against them and the HFT's pull their sub-penny quotest) so when HFT's pull their quotes, the Bid/Offer can jump by multiple cents/share, which happens pretty much any time a large order is placed by mutual funds.

Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.

This has the downside that you can trade only once a day, which works best for index funds that price at the market close anyway. For actively managed funds that respond to news this delay can be a big disadvantage.

If the exchanges were still non-profits they would not be so beholding to the HFT's (their largest customers in terms of generating exchange fees for trades) and would probably by now have offered hourly Market-on-the-Hour (MOH) or Market-on-the-minute (MOM) orders to allow customers to bypass the shenanigans of the HFT's. If the SEC were not so politicized they would demand that the exchanges offer MOH and MOM orders.

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Re: Brokers sell ETF order flow used to trade against clients

Post by SlowMovingInvestor » Sun Jul 15, 2018 5:36 pm

ananthar wrote:
Sun Jul 15, 2018 5:21 pm
Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.
Very interesting -- but I'm not sure most online brokerages allow market-on-close orders to retail customers.

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Re: Brokers sell ETF order flow used to trade against clients

Post by triceratop » Sun Jul 15, 2018 5:37 pm

SlowMovingInvestor wrote:
Sun Jul 15, 2018 5:36 pm
ananthar wrote:
Sun Jul 15, 2018 5:21 pm
Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.
Very interesting -- but I'm not sure most online brokerages allow market-on-close orders to retail customers.
A mutual fund order is a MoC order. :)

(yes yes, I know ananthar was talking about mutual fund managers using MoC orders to manage fund flows)
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Re: Brokers sell ETF order flow used to trade against clients

Post by drk » Sun Jul 15, 2018 5:54 pm

SlowMovingInvestor wrote:
Sun Jul 15, 2018 5:36 pm
ananthar wrote:
Sun Jul 15, 2018 5:21 pm
Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.
Very interesting -- but I'm not sure most online brokerages allow market-on-close orders to retail customers.
E*Trade does, but it doesn't let you specify the exchange.

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Re: Brokers sell ETF order flow used to trade against clients

Post by Whakamole » Sun Jul 15, 2018 5:55 pm

SlowMovingInvestor wrote:
Sun Jul 15, 2018 5:36 pm
ananthar wrote:
Sun Jul 15, 2018 5:21 pm
Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.
Very interesting -- but I'm not sure most online brokerages allow market-on-close orders to retail customers.
Fidelity lets you do "on the close" orders.

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Re: Brokers sell ETF order flow used to trade against clients

Post by ananthar » Sun Jul 15, 2018 6:03 pm

drk wrote:
Sun Jul 15, 2018 5:54 pm
SlowMovingInvestor wrote:
Sun Jul 15, 2018 5:36 pm
ananthar wrote:
Sun Jul 15, 2018 5:21 pm
Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.
Very interesting -- but I'm not sure most online brokerages allow market-on-close orders to retail customers.
E*Trade does, but it doesn't let you specify the exchange.
MOC (and the corresponding MOL limit orders) only trade on the primary exchange (on which the stock is listed), which is either NYSE or NASDAQ. This may change since CBOE has applied for permission to compete with the primary exchanges and offer MOC (but NOT MOL) orders : If approved, CBOE trading for MOC would begin Jan 2019.

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Re: Brokers sell ETF order flow used to trade against clients

Post by FrugalInvestor » Sun Jul 15, 2018 6:07 pm

I like to KISS which for me means Vanguard mutual funds directly through Vanguard. This is just more noise I can ignore as a result.
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Re: Brokers sell ETF order flow used to trade against clients

Post by drk » Sun Jul 15, 2018 6:13 pm

ananthar wrote:
Sun Jul 15, 2018 6:03 pm
MOC (and the corresponding MOL limit orders) only trade on the primary exchange (on which the stock is listed), which is either NYSE or NASDAQ. This may change since CBOE has applied for permission to compete with the primary exchanges and offer MOC (but NOT MOL) orders : If approved, CBOE trading for MOC would begin Jan 2019.
Noted! Thanks for the information.

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Re: Brokers sell ETF order flow used to trade against clients

Post by KSActuary » Mon Jul 16, 2018 12:16 am

ananthar wrote:
Sun Jul 15, 2018 5:21 pm
The sale of order flow typically has a small negative effect for small orders but a very large negative effect on large orders (such as typically executed by mutual funds). Even if you use a broker that does NOT sell order flow (or direct your orders to the largest exchange offering Best Bid/offer) your order is still negatively impacted by the fact that HFT's (and other so-called market makers) alone have the right to place limit orders in 0.01 cents/share increments, and hence can force the orders to be rerouted to their small venues since these temporarily become the Best Bid/Offer, and then the HFT's cancel their sub-penny quote (along with the any similar quotes on other venues) and then force a fill at the next best Bid/Offer (+ 0.01 cents/share). Worse yet this has been happening for so long now that all non-HFT limit order liquidity provided by retail traders has dried up (since most retail traders have figured out their limit orders will never get filled unless the market is moving against them and the HFT's pull their sub-penny quotest) so when HFT's pull their quotes, the Bid/Offer can jump by multiple cents/share, which happens pretty much any time a large order is placed by mutual funds.

Fortunately mutual funds have figured out a way to avoid the HFT's, that can be used by anyone : Place all buy-sell orders as Market-On-Close orders on the primary exchange. All buy and sell orders placed as Market-On-Close orders will be traded at the close in a single auction (so all the buys and sells settle at the same price). This not only has the advantage that there is no bid-ask spread, it is also much harder for the HFT's to game since the total order volume is so large : On the NYSE over 30% (probabably over 50% soon) of the daily volume now happens at the daily close.

This has the downside that you can trade only once a day, which works best for index funds that price at the market close anyway. For actively managed funds that respond to news this delay can be a big disadvantage.

If the exchanges were still non-profits they would not be so beholding to the HFT's (their largest customers in terms of generating exchange fees for trades) and would probably by now have offered hourly Market-on-the-Hour (MOH) or Market-on-the-minute (MOM) orders to allow customers to bypass the shenanigans of the HFT's. If the SEC were not so politicized they would demand that the exchanges offer MOH and MOM orders.
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Re: Brokers sell ETF order flow used to trade against clients

Post by Caduceus » Mon Jul 16, 2018 10:27 am

I don't understand some of the more technical bits in the discussion. What do you mean by selling ETF order flow - can you explain it more simply?

Is it that the broker sells the information (for example, that I want to buy 10000 shares) to some HFT firm, which then immediately buys the 10,000 shares and re-sells it at a slightly higher price to my broker/me? If so, then how does this work, because isn't my broker required to get the best asking price?

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Re: Brokers sell ETF order flow used to trade against clients

Post by David Jay » Mon Jul 16, 2018 10:32 am

Caduceus wrote:
Mon Jul 16, 2018 10:27 am
...isn't my broker required to get the best asking price?
No. That's the point.
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Re: Brokers sell ETF order flow used to trade against clients

Post by Caduceus » Mon Jul 16, 2018 10:33 am

David Jay wrote:
Mon Jul 16, 2018 10:32 am
Caduceus wrote:
Mon Jul 16, 2018 10:27 am
...isn't my broker required to get the best asking price?
No. That's the point.
What is the NBBO guarantee then? Doesn't NBBO guarantee that the broker must execute customer buy-trades at the best asking price available?

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Re: Brokers sell ETF order flow used to trade against clients

Post by vineviz » Mon Jul 16, 2018 11:00 am

David Jay wrote:
Mon Jul 16, 2018 10:32 am
Caduceus wrote:
Mon Jul 16, 2018 10:27 am
...isn't my broker required to get the best asking price?
No. That's the point.
I think you are confusing several different aspects of trading systems.

Brokers ARE, indeed, required to execute customer trades at NBBO prices and quantities. The only way they can legally deviate is if the NBBO quantities are less than the customer's market order quantities.

Trades move fas so the market price can sometimes move away from the NBBO price, but brokers are still required to meet NBBO.
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Re: Brokers sell ETF order flow used to trade against clients

Post by David Jay » Mon Jul 16, 2018 11:30 am

Caduceus wrote:
Mon Jul 16, 2018 10:33 am
David Jay wrote:
Mon Jul 16, 2018 10:32 am
Caduceus wrote:
Mon Jul 16, 2018 10:27 am
...isn't my broker required to get the best asking price?
No. That's the point.
What is the NBBO guarantee then? Doesn't NBBO guarantee that the broker must execute customer buy-trades at the best asking price available?
Both are true. Your broker gets the best asking price, but that "best" price is higher than it could have been if not for the HFT component. So yes, they followed the NBBO guarantee. And yes, they took money out of your pocket.
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Re: Brokers sell ETF order flow used to trade against clients

Post by afan » Mon Jul 16, 2018 12:24 pm

The only ETFs I buy are highly liquid with one cent bid ask spreads. I don't see a reason to buy anything else. I suppose HFT outfits could make a profit inside that $0.01 spread by trading so many shares that it is worth the effort. But the effect on me appears invisible. I still face a one cent spread.

Since the ETFs are so liquid it would take orders thousands of times larger than mine, at least, to see a market impact.

This could be an issue for people trading illiquid ETFs- a bad idea, for people trading illiquid individual stocks- a bad idea, or doing day trading- a terrible idea. For all but the Forbes 400, our orders will be too small to move the S&P500, TSM or the bond market.

These concerns easily could be problems for mutual funds or ETFs themselves. They have to make large trades and have to buy individual stocks or blocks of stocks. But mutual funds and ETFs have a variety of methods for mitigation.

If I were to enter the class of people for whom this matters I would investigate how to counter it. Based on my limited knowledge at this time, IB sounds like the place to start.

Liquid ETFs, limit orders, worry about something important.
Last edited by afan on Tue Jul 17, 2018 4:57 am, edited 1 time in total.
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Re: Brokers sell ETF order flow used to trade against clients

Post by Earl Lemongrab » Mon Jul 16, 2018 12:52 pm

There are many ways to evaluate the situation. I have over $1 million in stock ETFs, none of which are held at Vanguard. If I used mutual funds instead, I'd have to either move everything there to get Admiral shares or use Investor shares. The latter would cost me somewhere in the neighborhood of 10 basis point in expense ratio. That's over $1000 a year. I'll bet I'm not losing anywhere near that in trades.
Last edited by Earl Lemongrab on Mon Jul 16, 2018 11:32 pm, edited 1 time in total.
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Re: Brokers sell ETF order flow used to trade against clients

Post by afan » Mon Jul 16, 2018 4:18 pm

According to Vanguard
Vanguard Brokerage does not receive compensation for directing order flow in
equity securities.
https://personal.vanguard.com/pdf/v719.pdf

They do it for options, but not many people should be trading options.
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