Who, Who, Who, Who?
Vol #122: March 23, 2023
Early internet browsing was littered with pop ups spamming you at every corner.
If it wasn’t banner ads blinking circus colors, it was windows exploding in front of every how-to article. Pop up blockers were slowly integrated into browsers, and now our best and brightest minds have traded restricted equity for intelligent cookies that show non stop ads for the toy you just bought on Amazon.
The most tedious part of web navigation has now become the prophylactic terms and conditions one must accept at every new page. Anyone opening Chrome or Safari in the European Union is constantly demanded to manage their data sharing preferences. California citizens have the right to request twice annually the data that has been collected related to them and ask that it be deleted.
Whether it’s GDPR or the California Privacy Act, consumers are slowly taking back their right to privacy. This legislation can be sweeping and broad in its interpretation. While it’s annoying to always have pops up asking you to “Accept All” or “Deny”, there are many nuances to managing personal data.
Selling or sharing your personal information is specifically defined by California in the context of behavioral advertising. This means you can tell Amazon they are not allowed to share the details they have about you with advertisers who pay for screen space via display ads. The watch company doesn’t know who YOU are, but they are paying for visibility amongst all the little Hansels leaving breadcrumbs of browser history.
When this legislation first came out in 2018, I still remember the conversation when an industry compliance expert suggested that taken literally, this could even apply to payment for order flow (PFOF). Not dissimilar to an internet marketer, a wholesaler is also paying for a certain type of customer.
The very name PFOF implies a solicitous quid pro quo. It’s using dollars to redirect business from the lit market mechanism. The fact that Bernie Madoff was instrumental in its implementation doesn’t help its reputation either.
When John Doe sends an order to TD Ameritrade, the fact that he’s John Doe and not PIMCO is delineated by the tagging of that order as coming from a market participant of the type “Customer”. Market makers get their own tag, and other institutions get marked as “Firms”. Since 2009 the “Professional Customer” designation also exists for high volume participants that fit into neither category.
This tagging determines several different elements of how your order is handled. At the exchange level, it will result in different fees being assessed. Certain market models let customers trade for free. Others offer reduced take rates or higher posting rebates.
Execution priority can also depend on an order's clearing range. If there are two ten lots bid for $1.20, and 10 contracts arrive to sell at $1.20, how are those divided? For certain exchanges it’s first come first served, but in a pro-rata model the customer trades first, and everything else gets split amongst the other players based on size displayed.
Being a customer has a lot of advantages in the options markets. By giving away this tiny little detail of personal information (“I’m not a pro”), you get to trade first and cheaper.
If your head is swimming with the complexities of how to route an order across sixteen exchanges with pages of fee tables and rules about priority, don’t worry, your friendly neighborhood wholesaler will take care of this for you - and pay you (your broker) for that privilege.
The fact that customer orders trade differently is only a part of what makes them desirable to handle as a wholesaler. Expertly navigating market structure, a wholesaler can capture additional rebates to help subsidize their cost to purchase the right to execute that order.
But a wholesaler isn’t just interested in the fee arbitrage, their principal business is to trade and warehouse inventory. Price and size equal, would you rather buy a ten lot for $1.20 from John Doe or PIMCO?
Knowing someone is a customer tells you a couple of different things. The first relates to market impact. Orders coming from retail customers are likely to be somewhat directionally random. Absent Redditors’ attempts to gamma squeeze AMC, the next order down the pipe from a customer feed is just as likely to go one way as another.
Institutions are much more likely to be moving size, and size moves markets. It’s not about whether the calls they are selling finish out of the money, it’s whether you’re stepping out front to buy the first contracts that eventually get sold down much lower as the market reprices expectations.
Institutions are also more likely to be playing a higher order game in the market place. While there are plenty of smart customers, their objectives tend to be orthogonal to dealers. This is the ideal trade - different dimensions meeting over price. A customer selling covered calls or buying protective puts cares more about price levels than volatility levels. If another market maker is selling calls to you, it’s time to check your dividend rates or term structures.
Baring your private details is so valuable to a wholesaler that they’ll even give you better prices. Part of this is mandated - if a marketable customer order comes across a wholesalers desk, they’re required to put it in a price improvement auction. (Marketable meaning the buy (sell) price is at or through the best offer (bid). A non-marketable order would simply get posted to tighten or improve the current bid-ask spread.)
It’s also good business to pay up for orders that are unlikely to have significant market impact. Collecting three cents of edge that doesn’t budge is a lot better than collecting a dime that evaporates as dozens of orders flood in the same direction.
The “Professional Customer” designation was created because of just how well “Customer” orders are treated. Certain firms were able to set up institutional grade trading infrastructure and wire that up to a standard customer account. By abusing priority and fee schedules, they boxed out other participants.
The rule now states that anyone sending in more than an order per minute (390 per day on average) gets bumped into the Pro Cust bucket where they are treated the same as a Firm. Interpretations continue to get bent here. Bill Clinton famously pondered on the definition of “is” and savvy participants are reinventing what they define an “order” as. For example if an order is expressed in volatility terms, then constantly readjusting the price for stock movement doesn’t count towards your 390 cap. Clever.
Advertisers will argue that they are paying for customers' private information in order to serve them better. Knowing what your browsing history looks like means you can get a lot more relevant content - at least according to those trying to sell it. Wholesalers love knowing who you are, so they can have the privilege of warehousing your risk.
It’s tempting to hit the “Deny All” button. Most websites I’m visiting don’t really need to know much about me, and further don’t need to be dropping breadcrumbs to remind me later. While PFOF doesn’t necessarily fall into the opt out category (yet), it’s a worthwhile example of how sometimes giving up a little bit about yourself can make the deal better for both sides.