October 25, 2019 On the Cost of ‘Free’ Trades Don Ross PDQ Enterprises Follow | Profile | More Share The investment world is caught up in the hype over zero-commission retail trades. While day traders, with their hundred-share orders, are happy, however, progress for institutional traders has been minimal. Though their electronic commission rates have also fallen, by roughly half over the past decade, the vastly higher market-impact costs they suffer have barely budged. “Price of Trading Hits Zero,” trumpeted the venerable Wall Street Journal on Oct. 2. Imagine that: zero! Three hundred thousand years after homo sapiens began roaming the earth, markets finally achieved frictionless perfection. Nothing. Nada. Free. The pinnacle of human achievement. In the corridors of 100 F Street, bureaucrats high-fived. “Our work is done here,” announced one tearful securities lawyer. Still, there were naysayers. In Boston, New York, Chicago, San Francisco, and other cities around America, institutional traders, the Greta Thunbergs of capitalism, shook their heads in disgust. They knew that trading was still far from free. “You have stolen my dreams and my performance with your empty words!” shouted one irate buy-sider, disrupting a celebratory day-trading conference.” “And yet, I am one of the lucky ones,” she continued. “P&L is suffering. Information is leaking. Entire portfolios are lagging. We are in the beginning of a mass underperformance, and all you can talk about is zero-commissions and fairy tales of instant executions. How dare you!” Sure, the day traders, with their hundred-share orders, and eye-rolling spouses telling them to get out of the house more, are happy. Their hobby is cheaper and easier than ever. But for the institutions, with orders of 40, 50, 60 thousand shares to fill, progress has been minimal. Though their electronic commission rates have also fallen, by roughly half over the past decade, the vastly higher market-impact costs they suffer have barely budged. Our markets, you see, were not built for institutions. They were built for the little guys – guys with little orders. We have complex and costly market-linkage and order-handling rules to protect their orders. But is this really good public policy? Institutions, after all, control some 80 percent of U.S. market cap, and they do so on behalf of tens of millions of fund-holders – many of whom depend on their returns for financing retirement. Building markets around hundred-share orders is contrary to the interests of fundholders. Their fiduciaries, the institutions, must, in order to trade effectively in such markets, over-invest in people and technology to chop up massive orders so as to appear like hundred-share Schwab clients. Vanguard may have 50,000 shares of IBM to buy, and Fidelity may have 50,000 to sell. But how do they find each other? They place hundred-share orders onto the exchanges and dark pools all day long, repeatedly, hoping to find evidence of liquidity. It’s like sticking your fingers into a fan to see if it’s spinning – it’s painful, it’s bloody, and it’s costly. A popular alternative method for sourcing institutional liquidity – placing conditional orders at venues that will match counterparties bilaterally at the NBBO midpoint – is hardly a solution. Though it enables the possibility of matching large blocks, it only works when a buyer and seller institution happen to bump into each other at a given point in time, within the narrow corridor of the NBBO – which is itself set by unrepresentative retail-sized orders. Fortunately, there is a better way. Instead of incessantly trading hundred-share orders bilaterally and sequentially, or groping in the dark for a single large counterpart, institutions can use modern technology to trade 50,000-share orders multilaterally and simultaneously. With little or no market impact. Really. Consider this actual trade on CODA Markets – the young platform which my firm runs: The auction-caller who initiated this block transaction – 74,400 shares – revealed nothing except an interest in trading Pfizer. Within a matter of seconds, though, matching liquidity was found, and 50 times the lit quote-size was executed with no discernible market impact. [Related video: “Rethinking Equity Market Structure and Reinvigorating Liquidity: Jim Ross, CODA Markets”] So what is holding back mass adoption of better trade mechanisms – mechanisms like ours, designed for institutional-sized trades? First, inertia. Not all institutional brokers are as yet geared up for directing order flow to high-tech, on-demand auctions. Improving performance measurement is a prerequisite for improving performance. Unfortunately, too many institutional trading desks are still using trading-cost analysis tools that were barely adequate for the legacy hundred-share bilateral-execution systems that still dominate the landscape. They need updated TCA tools that better capture the benefit of executing large block trades with minimal market impact. To the extent that they’re still using game-able nonsense like VWAP, they simply don’t know what they’re missing. Second, public policy. The order-protection mandate means that we have to graft on expensive technological barnacles to satisfy tiny orders elsewhere. Filling such tiny orders can result in missed trades, higher-than-necessary impact, and additional explicit costs. Even though the net benefit of block executions outweighs such side costs, their existence is still a drag on adoption. Eliminating them would be good public policy – policy focused on the needs of the 80 percent. Don Ross is the CEO of PDQ Enterprises, LLC, the parent company of CODA Markets, Inc., a FINRA regulated broker-dealer which operates an electronic alternative trading system under SEC Regulation ATS.
Friggin locusts. Markets were initially built and intended to be fair and equitable. That meant that small orders were not disadvantaged over large orders and vice versa. But that has changed. Exchanges became profit centers and now in their never ending thirst to squeeze out more profits sold out to those who pay for unfair advantages. A limit order at a certain price level can be easily frontrun. Who profits? Large players with large orders. Who pays? Small orders. How? Via missed fills and inferior execution. Anyone who claims the market serves small investors should be beaten in the face with a large baseball bat for spreading lies and falsehood.