Cash for the Limo

Vol #188: August 1st, 2024

Scene:  Mid-1990s, Friday night,  a dim middle school cafeteria. 

Boys are glued to gates shuttering off the lunch counters, while the girls have their backs to the windows. There’s a 20 foot gap between potential dance partners. 

The Macarena comes on.

Not yet a cliche, we know the moves, and it unglued us from the comfortable awkwardness. If a macaroni screensaver and DNC delegation can do this, so can I. 

As soon as the hands stop clapping, I’m lost. Slow dances are another story. Asking was mortifying, and what to do if you got a yes? Invitations got easier as homecomings, spring flings, and proms passed by. Dancing never particularly did. I bailed after class number two for my wedding intro. 

With my two left feet, there was always a nagging thought that someone could cut in. I’d seen it in the movies, and a fragile adolescent ego couldn’t handle that. Breaking up dance partners feels cloak and dagger, as much as I deserved it. 

What if Ricky Martin walked into East Ridge Middle School and stole my poor teenage heartthrob? Probably a win for everyone.

Markets don’t particularly care about the feelings of participants, and optimize for one priority - price discovery. Each side of an order is entitled to get the best price available to them at that moment.  The better dance partner wins. 

Best execution is a complicated definition. In most cases it’s simply the best price - you wouldn’t route an order to pay $1.35 when you could pay $1.30 somewhere else. But what if sending your order to a venue with a slightly higher price on this order meant you hit a volume tier that reduced fees for all customers that month?  

As we move out the liquidity spectrum, the math gets even fuzzier. Would you choose a counterparty that always provides good markets, or the marginal price improvement you get from a fickle liquidity provider. Choosing absolute price risks cutting off your pipeline and having no price in the future. 

In isolation, the question here is simple. But when liquidity is fragmented across 16 lit venues, each competing for the right to execute that order, how to consistently facilitate price discovery is complex. 

The giant wheel of orderflow in equity options puts wholesaling market makers in a unique position. They match their liquidity against customer interest, and submit that to a price improvement auction. This is structured such that no matter how wide a lit market is, trades can’t cross without being exposed to participants who might offer a better price. 

This structure has distinct advantages, but fees are not so straightforward. In order to incentivize a wholesaler to bring the order to market, they get paid a break up credit if someone swoops in to better the price. And that credit is funded by a fee charged to the responder. 

Sorry I took your dance partner, here’s some cash to cover the corsage and limo. 

Bringing that order to market is not free. It’s the sunk costs of cultivating the business relationship and building the infrastructure, but also the incremental payment for orderflow (PFOF) on every single contract. Layer on (nicely discounted) exchange fees, and without that credit, you just paid for your competitor’s lunch. 

Traders want to trade. Wholesalers buy the orderflow because they want to warehouse the risk. HFTs can flip equities back and forth only to skim fees, but options have too many vectors that mandate dealers holding inventory. Because they can charge a theoretical edge for that, they want to do that. In size.

The break up fee is a consolation prize at best. Every order in an auction is exposed to competitive forces, and liquidity providers must match the pricing of the market if they want to stay in business. These kickbacks are a subsidy to soften the blow for what they’ve already done. 

But why are the responders funding this subsidy? In a market mechanism designed to get priority customers the best execution price, players willing to improve can be handicapped by over a dollar in fees per contract. Assuming any reasonable edge retention numbers, and that precludes a response in a majority of actively traded products. 

When these fees were first escalated in 2016 it was controversial. The AMEX quintupled break up charges, and four of the five largest wholesalers wrote letters opposing this both separately and together. Several of the largest non wholesaling market makers also disapproved. 

In most cases the exchanges still generate revenue per contract net of subsidies. Because there are so many other variables like volume tiers and additional rebates the arithmetic isn’t perfectly simple, but on the MIAX the net is a full $0.25/$0.50 for pennies/non-pennies. At the other extreme is a venue like EDGX that shaves that margin to only $0.09 in non-pennies before any other credits to the initiator. 

This isn’t an exchange money grab however. The complaints from all sides are that it introduces too many barriers to competition and erodes market quality. It’s lopsided when the initiator only pays $0.05 to trade at the same level a responder could pay $1.15. 

To be fair, in aggregating all the costs that bring this trade to market, the initiator has already paid something for this order. Perhaps not $1.15, but PFOF levels are significant and trend north of $0.70 in many cases. The exchange fee gap is disproportionate, but total execution costs are much closer. 

The break up fees are essentially an additional layer of PFOF. The responder fee is passing through the exchanges to the wholesalers, and ultimately ending up at a broker.  The cost of bringing customer liquidity to the marketplace has been socialized, and rents are captured by the service providers along the way. 

While many of the market makers object to this on the grounds that it widens markets, that argument is complex. In a simple example, a responder’s best price will be net of the costs, so increasing fees lowers bids and raises offers. But if wholesalers aren’t compensated when someone else trades the order they paid for, their cost per contract goes up and execution quality suffers in aggregate. 

The real argument is that the system subtly shifts the power into the hands of consolidators. A wholesaler has a capture advantage at the same price level. They get additional contracts allocated, and in many mechanisms are given a “free call” to match a respondents price. The flip side is they’re backstopping this execution quality and broker payments. What’s the right comp for that?

Given the way customer orderflow is brought into the options ecosystem, break up fees have become a necessary evil. All participants benefit from the fact that wholesalers bring orders to the market. How equally is subjective. 

Exchanges argue that the competitive dynamics between them keep fees in check. That has some weight. Choosing EDGX when you expect to get broken up (and are happy to not take that risk) is offering a different value proposition than a venue who doesn’t pay anything. Volumes move every month based on subtle fee changes. 

The price of customer orderflow is driven by its value. The market is fairly efficient at extracting that - both broker and trader keep close tabs on their PnL. Trickle down the line, and break up fees will move towards accounting for that pricing. 

However the charges here are a distraction from the structural advantages that allow certain participants to trade more or more cheaply. For markets to serve their function as pricers and capital allocators, it’s the rules of the game that dictate as much as the costs to play. 

Paying back cash for the limo is one thing, but you also have to be careful about how many cut-ins are allowed.