Month: July 2022

Authored by Lance Roberts via RealInvestmentAdvice.com,

“Payment For Order Flow” remains a contention between retail investors and Wall Street. On the one hand, it creates the ability to have “free trading” for retail investors. However, it also creates an opportunity for Wall Street to “front-run” individuals for profit.

In financial markets, “Payment For Order Flow,” or “PFOF,” refers to a broker’s compensation from third parties to influence how the broker routes client orders for fulfillment.

Read that again.

For years, paying for order flows allowed firms to centralize customers’ orders for another firm to execute. Such allowed smaller firms to use economies of scale of larger firms. Such enables small firms to combine orders with larger firms, providing better execution quality.

Over the years, the decimalization of the trading securities diminished the profitability of trade execution. Such pushed Wall Street toward payment for order flow as a way to generate revenue and subsidize the move to zero commissions.

Technological advances and data analysis increased the speed with which information gets sent and received. Over the last decade, Wall Street spent billions to figure out ways to take advantage of the data and “game the system.”

Today, Robinhood and others generate the bulk of their revenues from payment for order flow by selling orders to the highest bidder. 

Think about this carefully. If a firm is selling order flow to the highest bidder, even though you are paying “zero commissions,” you are not necessarily getting the best execution.

In other words, “free” isn’t necessarily “free.”

The Fleecing Of Retail Investors

The issue of payment for order flow is not a new thing. In 2004, Citadel’s attorney Jonathan G. Katz wrote a letter to the SEC making a definitive argument the practice of selling order flow should be illegal.

Source: https://www.sec.gov/rules/concept/s70704/citadel04132004.pdf

Think about that for a moment.

• In 2004, Citadel argued that payment for order flow should be illegal to the SEC.

• In 2020, Citadel is the largest firm in the payment for order flow business.

Citadel decided that “if you can’t beat ’em, join ’em” was the best game plan.

What happened between 2004 and 2020?

During the waning days of fractional pricing, the smallest spread was ⅛ of a dollar, or $0.125. Spreads for options orders were considerably wider. Traders discovered “free” trades cost them quite a bit since they didn’t get the best transaction price.  

At that point, the SEC did step in to conduct a study. The result was a near ban on payment for order flow. The study found, among other things, that the proliferation of options exchanges narrowed spreads due to the additional competition for order execution.

In the end, under pressure from Wall Street, the SEC acquiesced and allowed the practice to continue stating:

“While the fierce competition by increased multiple-listing produces immediate economic benefits to investors in the form of narrower quotes and effective spreads. By some measures these improvements get muted with the spread of payment for order flow and internalization.” 

That decision opened “Pandora’s box.”

No Such Thing As Free Trading

Better Markets previously wrote:

“As is clear from the billions paid for, and made from, order flows, there is no such thing as ‘free trading.’

Thus, the claim of ‘commission-free trading’ is no more than a rhetorical ruse to attract new investors. Such distracts them from the billions of dollars in PFOF and other hidden costs that come out of retail investors’ pockets.

These intermediaries are often merely transferring the investors’ visible upfront commissions into invisible after-the-fact de facto commissions.

Such enables the complexity of the fragmented order processing system that one could argue is designed primarily to hide those payments.” – Better Markets

Such is why Wall Street lobbies the SEC heavily to look the other way. They also continue to obfuscate the “racket” under the guise of “creating market liquidity.” However, liquidity would remain in a world without payment for order flow. Wall Street would merely shift focus back to market-making.

But, if you don’t think this is a “big deal,” you are sorely misinformed.

“Brokerages such as Charles Schwab Corp., TD Ameritrade, Robinhood Markets Inc., and E*Trade collected nearly $2.6 billion in payments for stock and option orders. The biggest sources of the payments were electronic trading firms such as Citadel Securities, Susquehanna International Group LLP and Virtu Financial Inc.” – WSJ

“Such firms make money by selling shares for slightly more than they are willing to buy them, and pocketing the price difference.”

So, exactly why would firms pay for order flow?

They are willing to pay for order flow from online brokerages because they are less likely to lose money trading against individual investors than on an exchange, where traders tend to be larger and more sophisticated.” – WSJ

 

The SEC’s Plan To Fix It?

Once again, the SEC is looking at fixing the payment for order flow practice.

“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges. It’s not clear, given the current market segmentation, concentration, and lack of a level playing field, that our current national market system is as fair and competitive as possible for investors.” – SEC Chairman, Gary Gensler

The Wall Street Journal went into more detail about what was currently getting considered:

“Chairman Gary Gensler directed SEC staff last year to explore ways to make the stock market more efficient for small investors and public companies. While aspects of the effort are in varying stages of development, one idea that has gained traction is to require brokerages to send most individual investors’ orders to be routed into auctions where trading firms compete to execute them.

The most consequential change being discussed would affect the way trades are handled after an investor places a so-called market order with a broker to buy or sell a stock. Market orders, which account for the majority of individual investors’ trades, don’t specify a minimum or maximum price the investor is willing to pay.

Mr. Gensler has said he wants to ensure that brokers execute orders at the best possible price for investors—the highest price for when an investor is selling, or the lowest price if they are buying.” – WSJ

The SEC is considering an “auction market” that would force firms to compete with each other to fill an individual investor’s trade. That change would impact how firms like Citadel Securities and Robinhood Markets process retail trade orders.

Now you can understand that “free trades” weren’t that “free” after all.

The Other Problem Of “Free Trades”

The other “free trading” problem is that it also leads to poor investor outcomes. As noted recently by the CEO of the investment app “Stash:”

“The entire way that trading is happening right now in the market and how payment for order flow is working. It is driving a casino effect where everyday Americans who don’t know how to trade and don’t have financial education supplied to them at school and from their parents are actively trading. And I want to understand how market structure will change to make it about the retail customer. The institutional customers and the hedge funds, they’ll be OK, but I want to make sure that we’re protecting retail investors.

Payment order flow has had a spiral effect where it just made it really, really easy to trade and actively trade. I think that it does benefit the market makers and the high frequency trading firms. Whereas, what I want to see is more retail customers thinking about the long term and investing slowly.”

As we noted previously, numerous studies prove more frequent trading leads to worse performance over time. Such is due to the emotional mistakes investors make, primarily of buying high and selling low, but also tax issues and trading costs associated with frequent trading.

The problem with free trading is that humans tend to overreact to good or bad news. This emotional reaction causes illogical investment decisions. This tendency to overreact can become even more significant during personal uncertainty or when the economy is terrible.

An entire field of study researches this tendency to make illogical financial decisions. It documents and labels our money-losing mind tricks like “recency bias” and “overconfidence.”

While the reasons for underperformance are many, commission-free trading exacerbates that trend by removing the “brake pedal” from the speeding car.

The Return Of Commissions

As Better Markets concluded:

“There is no reason for the markets today to be so fragmented other than to serve as a wealth extraction mechanism that moves money from buy-side pockets to sell-side firms, intermediaries, and their affiliates.

However, it isn’t just Robinhood and a couple of hedge funds but a collaboration of every Wall Street player.

I am a firm believer in “free markets.”

However, for “free markets” to work effectively, they must also be “fair markets.”

Our current capital market system may be “free,” but it is not “fair” in many ways. Banning payment for order flow is a good start.

Yes, such would mean that firms providing transaction services would have to charge a commission for execution. But such would potentially have the knock-off effect of “slowing things down” and providing better investor outcomes.

However, while this was an exercise in understanding payment for order flow and that “free trading isn’t free,” nothing will likely change. As is always the case, there is too much money, power, and political pressure from Wall Street on the SEC.

We aren’t holding our breath that anything will change for the better anytime soon.

But maybe it’s worth realizing that paying a small commission for “fair execution” wasn’t so bad.

As we noted on Monday, the Biden administration has been mulling a rollback of Trump-era tariffs imposed on China.

The Wall Street Journal pointed out that the decision is constrained by competing policy aims – one one hand, easing tariffs would somehow, in theory, reduce inflation. On the other hand, several Biden admin officials see tariffs as “valuable leverage in getting concessions from China,” and would prefer to see a tariff cut paird with other measures designed to keep pressure on Beijing to change practices that put US companies and workers at a disadvantage.

So after several days of hand-wringing and rumor milling, Politico reports on Tuesday that Biden is now considering a minuscule rollback on just $10 billion worth of Chinese goods, while opening the door for a new exclusion process for firms to win additional relief.

The rollback would be just a fraction of the approximately $370 billion in tariffs slapped on China by the Trump admin.

The president in recent weeks held a number of meetings with senior economic advisers where options for a decision on the Trump-era tariffs were discussed, Bloomberg adds citing its own sources.

Politico also notes that the United States Trade Representative (USTR) has received over 300 requests to continue Trump’s tariffs as the “first stage of a mandatory four-year review comes to a close at midnight today.”

Meanwhile, top trade reps from the US, Mexico and Canada will meet in Vancouver, Canada on Thursday and Friday for the second meeting of the USMCA Free Trade Commission.

As we noted on Monday, Biden has been buffeted by policy disagreements both within his administration, and by outside forces including business, labor and lawmakers, which is why a plan to announce a tariff cut has been repeatedly postponed, as it reflects the “sharp divisions” within his own administration over the China tariffs.

Among his own cabinet, Treasury Secretary Janet Yellen – who recently admitted her cluelessness is behind the most catastrophic inflationary juggernaut unleashed in the US in more than 40 years – has called tariffs a drag on the economy, saying the administration is looking at ways to reconfigure them to help curb inflation. Yellen has said some of the inherited tariffs aren’t strategic and don’t address China’s unfair trade practices.

“Reconfiguring some of those tariffs so they make more sense and reducing unnecessary burdens is something that’s under consideration,” Yellen said in an interview with ABC News on June 19.

Most of Biden’s cronies, however, take the opposite view to that of the senile trasury secretary: on the other side are U.S. Trade Representative Katherine Tai and National security adviser Jake Sullivan, who see tariffs as valuable leverage in getting concessions from China. These skeptics want a tariff cut paired with another measure designed to keep pressure on Beijing to change practices that the U.S. says put American companies and workers at a disadvantage.

Authored by Zachary Stieber via The Epoch Times,

Independent journalist Alex Berenson and Twitter have agreed to a settlement over a lawsuit that alleged the big tech company violated Berenson’s constitutional rights when it banned him.

The parties “have reached a settlement in principle,” according to a joint stipulation filed in federal court in California on June 29.

However, additional time is needed to finalize details of the settlement, the parties said.

Lawyers for Berenson and Twitter, in the filing, asked U.S. District Judge William Alsup, a Clinton appointee, to extend deadlines to produce certain documents, known as discovery, in light of the agreement.

Alsup extended the deadlines by 14 days, less than the 28 days requested, and said that he would not allow any further extensions.

“Counsel are fully able to negotiate and litigate at the same time,” he wrote in an order.

The extensions mean Berenson had until June 30 to produce certain documents and Twitter has until mid-July to produce certain materials.

Additionally, Twitter can take a deposition of Berenson by the end of July and Berenson can take depositions of two current or former Twitter employees by mid-August.

Discovery

The filings contain no details concerning the settlement details.

Berenson said in an initial blog post that he couldn’t share details until the settlement is actually filed but later pointed out how he’d promised that “there would be no settlement without third-party discovery.”

Berenson emphasized he will not accept an agreement unless it allows him to not only obtain materials from Twitter, but to talk about those materials.

Twitter did not respond to a request for comment.

Twitter banned Berenson, formerly of the New York Times, from the platform in August 2021, claiming he violated the company’s rules against promoting COVID-19 misinformation.

Berenson said in the suit that he was assured by a senior executive that he would not be banned, that he did not break the rules, and that Twitter broke its promises and policies in removing him.

He accused Twitter of violating the U.S. Constitution’s First Amendment, federal laws, and the California Common Carrier Law, as well as breaching the user contract it entered with Berenson.

Twitter tried to dismiss the suit, but Alsup allowed it to proceed with the breach of contract claims.

“Here, Twitter allegedly established a specific, detailed five-strike policy regarding COVID-19 misinformation and its vice president gave specific and direct assurances to plaintiff regarding his posts pursuant to that policy. Any ambiguities in a contract like Twitter’s terms of service are interpreted against the drafter, Twitter,” he said in his order on Twitter’s motion.

“And, at the pleading stage, this order must construe all allegations in the light most favorable to plaintiff’s allegations. Plaintiff plausibly avers that Twitter’s conduct here modified its contract with plaintiff and then breached that contract by failing to abide by its own five-strike policy and its specific commitments set forth through its vice president.”

A few days ago, Deutsche Bank strategist Jim Reid asked if July 22 would be the most important day of the year for both Europe and the rest of the world, as that’s the day when Russian gas should resume transit on the Nord Stream 1 pipeline, to wit: “while we all spend most of our market time thinking about the Fed and a recession, I suspect what happens to Russian gas in H2 is potentially an even bigger story. Of course by July 22nd parts may have be found and the supply might start to normalise. Anyone who tells you they know what is going to happen here is guessing but as minimum it should be a huge focal point for everyone in markets.”

Hinting that they may have some clue what happens with Europe’s gas market in three weeks, overnight Goldman’s European commodity strategists wrote a note titled “Increased supply risks lead us to raise our TTF forecasts” in which they note that the 60% reduction in Russian gas exports via the Nord Stream 1 (NS1) pipeline in place since mid-Jun has left net Russian flows to NW Europe near zero, with most of what’s left in the pipe re-exported out of Germany towards Czech Republic and from there to other buyers. This has raised gas supply uncertainty in Europe ahead of NS1’s full maintenance in mid-July, driving TTF prices up 70% in the period to 168 EUR/MWh as a result, the highest since the Ukraine invasion in March.

Why does this matter? Because as Goldman’s Samantha Dart writes, while she initially assumed a full restoration of NS1 flows following its upcoming maintenance event, she no longer see this as the most probable scenario; “instead, the lack of resolution around required turbine repairs, and the absence of any Gazprom-driven re-routing of the reduced NS1 flows via an alternative pipeline to mitigate the impact to supply suggest a prolonged reduced flow rate at NS1 is more likely going forward.”

Accordingly, Goldman has revised its TTF price forecasts to reflect such a scenario around NS1 flows post maintenance. Specifically, the bank raises its 3Q22/4Q22/1Q23/Sum23 TTF price forecasts to 153/121/77/138 EUR/MWh from 104/105/76/75 previously, vs current market forwards at 163/166/159/106. In other words, the Q3 price is raised roughly 50% and the full 2023 price forecast nearly 100% higher!

Goldman’s revised forecasts embed a modal scenario of NS1 flows returning following maintenance at their current 40% run rate, while the bank still sees a full cut of NS1 flows made permanent as the least likely scenario, as shown in the table below.

This is because keeping export flows this restricted would largely leave Russia’s flow flexibility one sided – flows could only go up from there. Further, keeping NS1 at zero post maintenance would effectively eliminate most, if not all, of Russia’s TTF-indexed revenue from gas sales, limiting any revenue upside that would come from subsequent spikes in TTF prices. It would also imply an accelerated rate of Russian gas production shut-ins relative to the 9% year-to-date year-on-year decline in Gazprom production reported so far.

To be sure, the path ahead for European gas prices will be impacted by several different drivers, not least of which the level of storage at the end of summer the market will be comfortable with. Hence, Goldman’s price forecasts under each scenario shown in Exhibit 7 embed specific storage targets, as well as the estimated impact of mitigating factors such as coal restarts, government-led buy-backs of industrial gas, residential and commercial responses and potential incremental LNG imports:

• Storage targets at 90% full by end-Oct, 20% by end-Mar. While the EU has published an 80% full storage target for the end of this summer (and 90% full from next year), Germany and France have independently guided towards higher targets, at or above 90% full. Further, TTF price action since the NS1 cuts in mid June suggests the market is positioning to achieve storage levels above the 80% full EU target, contributing to lower supply uncertainty, and lower prices, in winter. The 20%-full storage target Goldman applies at the end of winter is enough to withstand a one standard deviation colder-than-average winter plus a small margin.
• Incremental coal and oil generation to reduce NW European gas demand by up to 22 mcm/d. In the NW European region GS includes the coal capacity increases announced in Germany and the Netherlands, adding up to an estimated 8 GW of coal-fired generation added over the course of the next several months, with the bank’s gas burn model suggesting 3 mcm/d of gas demand impacted by each 1 GW of energy generated with alternative fuels. While the latest rally in TTF prices has once again taken it above diesel costs in Europe (adjusted for burn efficiency and CO2 cost differentials), leading to lower gas burns at the margin, Goldman doesn’t see the potential gas-to-oil substitution for power in Europe as significant. Data for the past several months suggest a swing in oil generation in NW Europe of up to 0.6 GW only (Exhibit 8), equivalent to less than 2 mcm/d of gas demand, which is also embeded in the bank’s calculations.
• Government-driven reduction in NW European industrial demand for gas of up to 9 mcm/d. The lack of details behind Germany’s Emergency Gas Plan makes it difficult to estimate the timing, duration and the scale of potential government intervention in the industrial sector. Scenarios include a 0%-10% reduction in industrial gas demand driven by Government action, with the lowest reductions applied to the scenarios with highest gas availability, and the largest intervention assumed for the scenarios with lowest gas availability.
• Decline in residential and commercial (heating) demand for gas of up to 28 mcm/d. Here, Goldman assumes a 0%-7% drop in NW European heating demand for gas, with the highest drop associated with the tightest gas supply scenario. This is not dissimilar to the weather-adjusted swings in heating demand seen this year.
• Up to 20 mcm/d of incremental NW European LNG imports. Again, Goldman assumes that the tightest gas supply scenarios in Europe would lift TTF prices to attract the largest incremental LNG imports (up to 12%) into the region. That said, Goldman has low conviction in these estimates as LNG buyers outside of Europe have not responded to LNG prices in a stable manner. For instance, low spot market participation from India, Pakistan and Bangladesh earlier in the year has reversed given the heat wave these regions have experienced. Similarly, the pace of economic activity recovery in China in 2H22 and storage restocking in Northeast Asia ahead of the next winter will likely increase Asia competition for spot cargoes despite high European gas prices. The higher LNG inflows now assumed on balance into NW Europe lead Goldman to lower our Sum22/Win22-23/Sum23 JKM-TTF spread forecasts to $0/$0.40/$0.10/mmBtu from $0.50/$0.90/$0.60 previously.

Finally, while price-capping measures applied to Russian gas have also been discussed, Goldman – similar to us – does not believe that these will be effective in reducing Europe’s gas tightness or even gas prices at the margin, as such measures would not bring additional supplies into Europe.

Given the high volatility in the front of the curve and its expectation that the ongoing European tightness is not likely resolved in the near-to-medium term, it’s hardly a surprise that Goldman continues to recommend long TTF exposure further out the curve, on the Dec23 contract, currently priced at 104 EUR/MWh, and which Goldman sees rising by about 40%! An alternative way to express this view is to go long Sum24, since it’s pricing at much lower levels at 69 EUR/MWh, below minimum industrial-demand-destruction price levels of 75 EUR/MWh.

There is more in the full Goldman note available to professional subs.

Authored by Robert Wright via The American Institute for Economic Research,

America’s central bank, the Federal Reserve System (Fed), is currently decimating the US economy for the third time in its existence. Will the Fed’s strikeout be its final at bat, or shall fans of the American economy be burdened by this monetary John Gochnaur (the worst player in major league baseball history) for another century? Even though the Ty Cobb (arguably the best batter ever) of monetary systems, the Gold Standard, stands ready to pinch hit?

Remember, the Fed does not just try to control the macroeconomy, it tries to control it within political constraints. Recent events have exploded any notion that it is an enterprise independent of government, led by sophisticated technocrats just trying to find the right tradeoff between output and inflation. To some extent, it botches its job out of incompetence, like Gochnaur. To some extent, though, it puts its own interests ahead of those of the American people.

Strike one occurred during the Great Depression of the 1930s. The nation was still technically on the Gold Standard but the international monetary system was such a mess following the Great War (1914-1918) that the Fed enjoyed some domestic monetary policy discretion, the ability to expand or contract the money supply. 

The Fed’s monetary stance proved too loose during the 1920s, which helped stock prices get too frothy. Following the Great Crash in 1929, though, its stance was too tight. Moreover, it failed to help struggling small banks, many of which went under, dragging depositors with them. That led to successive waves of bank runs that stymied economic rebound until after the Policy Monster of Hyde Park got elected president in 1932.

Strike two was the Great Inflation of the 1970s. The Fed might be forgiven for this one because it occurred during a switch to a new monetary policy regime, a solution to the Trilemma or Impossible Trinity that granted it full domestic monetary policy discretionary for the first time by freeing the international movement of capital and allowing foreign exchange rates to respond fully to market forces.

But it was warned! For the better part of a decade, pundits like NBC Radio financial journalist Wilma Soss had predicted that large budget and trade deficits would necessitate the end of the Bretton Woods system of fixed exchange rates. That would lead, she presciently warned, to rampant dollar depreciation internationally, domestic inflation, scarcity-inducing price controls, and the euthanasia of individual stock and bond investors. 

The Fed fouled a pitch off during the Global Financial Crisis of 2008. Although it helped to create the subprime mortgage bubble with low interest rates and its wrong-headed thinking about financial exclusion, it did its job as lender-of-last-resort well enough to turn the economy around fairly quickly by massively subsidizing the banking sector. The tactics employed were suboptimal but at least the Great Recession did not turn into another depression.

The Fed, however, whiffed in 2020-21. It should have begun aggressively raising rates to combat the massive COVID fiscal stimulus that Congress passed that year. In fact, it could have saved America from the pain caused by the lockdowns merely by threatening to offset the stimulus with higher interest rates.

Lockdowns arguably made stimulus necessary, but the lockdowns themselves were clearly unnecessary. AIER vigorously argued against lockdowns for over a year, and its position has since been vindicated econometrically and scientifically. Unrestrained by lockdown regulations, retailers, gyms, and other businesses would have soon figured out that they simply needed to implement special hours or days for the maskers/vaxxers and other special hours or days for the antis. Experiments would have soon revealed which COVID protocols would be sufficient to suppress so-called superspreader events in various contexts, allowing most economic activity to continue relatively unimpeded without worsening the pandemic one iota.

But instead of sticking to its alleged two percent inflation target, the Fed caved in to pro-lockdown political pressure and kept interest rates low, even after the temporary threat of deflation had passed by the end of summer 2020 and prices began their steady ascent:

The Fed is finally raising interest rates aggressively but in the process it’s creating the largest operating losses in its history. Why, then, didn’t the Fed counteract massive fiscal stimulus with tighter monetary policy in 2021? Ultimately, it doesn’t matter. Bad batters always have excuses. The sun was in my eyes, the pitcher cheated, I’m just in a slump (aka my strikeouts are transitory), or I bet a lot of money on the other team. Meanwhile, fans in the stands know that it doesn’t matter, ya struck out!

No batter always gets on base but America, nay the world, has a high-quality pinch hitter that it benched a century ago: the Gold Standard. It’s not perfect but it is far better, and fairer, than the Fed. Returning to gold, or some other commodity standard, need not be scary. It just means replacing monetary policy technocrats of dubious ability or motivation with market forces, the same market forces that develop the products and technologies that seemingly magically appear whenever and wherever consumers want them. Money need be no different.