Subscribe Feed (RSS)Internalization of Orders
October 17th, 2010 by eyal | 8 Comments | Filed in Stock Market, Trading ResourcesThere is a fascinating speech by InteractiveBrokers founder, Thomas Peterffy to the World Federation of Exchanges in Paris posted on IB’s website. It is highly recommended for a look into how the brokers and markets work today from a technical perspective, how your orders are treated and why there is a big problem brewing with transparency, trust, fairness in dealings of exchanges and brokers and ability to handle market meltdowns such as the May flash crash. He seems to take stance that the troubles we’ve been seeing with flash crashes isn’t rooted in algo trading / HFT but with fragmentation of exchanges, clearing houses and ubiquity of internalizers. Here is the gist of it, the full speech is available here in PDF.
The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.
How do we know that the profits are huge? Just look at the banks’ quarterly financial reports on derivatives dealings. Even the more modest estimates exceed $100 billion per year, worldwide. Customers are on the other side of those trades. Customer losses are on the other side of those bank profits. The amazing thing is that those banks are able to convince their customers that this is good for them and moving these contracts on to the exchanges would harm the customers.It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!
These brokers ignore the exchanges and sell the orders to internalizers, thereby avoiding exchange fees and getting a nice little payment from the internalizers in return. This payment for order flow adds up to real money after millions of orders are taken into account. The internalizers are supposedly matching the best prices prevailing at the exchanges, so that they can argue that the customers get the best prices.But do they really? Of course not. If they did, an independent study would not have found that the one broker that actually routes the vast majority of its orders to public exchanges — and I will not name this broker again — obtains executions that are on the average 28 cents better per 100 shares in the U.S., and an absolutely stunning 2.84 Euros better per 100 shares in Europe.
The steps he proposes are mainly 3:
1. Forcing brokers to route to exchanges
2. Defragmenting the exchanges.
3. Consolidate clearing houses. Peterffy raises some good questions here about liquidity, solvency and ability of small clearing houses to handle crises.
H/T TraderGav
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Tags: clearing houses, derivatives, Exchange, fairness, hft, interactive brokers, internalization, market, online broker, securities and exchange commission, Stocks, Thomas Peterffy, transparency, U.S. Securities
