Access To Inside Market Prices: The Key To Better Retail Investment Performance.

Introduction

Have you ever wondered how important the costs of using brokers are to the value of your portfolio? After all, retail brokerage services are free now, so someone else must be paying for the roughly 100 transaction platforms including at least 13 SEC-approved exchanges, and the arbitrage high-frequency traders earn chasing the prices in these marketplaces across suburban New Jersey.

Unfortunately, right now there is no simple answer to the question – Who pays the bloated resource cost of running the National Market System (NMS)? But there is no reason why retail investors cannot know how much of this resource cost they pay.

This article shows the way retail can learn how much of Wall Street’s operations are paid for by the below-market prices retail gets.

The status quo in the NMS

The endgame for the NMS is too bizarre to have been planned. The NMS is split in two. One part populated by computers and exchanges serves computer-driven high-frequency traders (HFTs) the big three exchange management firms, and no one else. The other part is simply an OTC market where retail orders are filled at a below-market price by wholesale broker-dealers.

Thus, it is high time retail could access costless estimates of the share of retail portfolio value that is destroyed by these off-market securities prices. How important is the difference between Wall Street insider prices and retail investors’ prices? And how can retail investors gain access to Wall Street’s insider prices?

The key to understanding how Wall Street extracts its profits from failure to provide retail brokerage services at least cost is to understand how Wall Street hides the insider/outsider bid-ask spread that drives the profitability of retail broker-dealers and the wholesalers that pay them.

A full-service investor-focused firm could easily provide this information. (I call this all-services-in-one firm the simple market system (SMS)). To produce an unbiased estimate of the costs of using any retail broker, the SMS must be owned by retail investors.

How would this work? There would be a front-end service provided at no cost to any customer of any broker, and a back-end service provided for a nominal fee to customers of for-profit brokers and at no cost to SMS customers.

A brief description of the NMS fix

The front-end service- The front-end service would tell retail investors what to expect. The retail-friendly firm could provide free cost and price information along with other summary measures of each broker’s average performance at no cost in advance of transactions. A customer could then make a better-informed choice of broker.

The back-end service- And then the customer could track the post-transaction performance of her SMS account. This would show users of the SMS exactly how much of the customer’s money goes to them, and how much goes to SMS. The SMS could provide the same information to customers of other participating brokers as well with the cooperation of the other brokers. This would dramatically improve retail knowledge of the significance of the execution services of any broker she has chosen.

What standards could be set for the quality of information disclosure?

• The front-end information could be available continuously free of charge to all investors.
• It should be easy to understand, unbiased, and relevant.
• It must be provided by a neutral source – not by brokers whose profits are tied to investors’ broker selection.
• It should have teeth. Two requirements would assure that investment information is useful.

• It should be subject to market discipline – the information provider should offer the relevant investment services itself at the reported cost.
• After investing, each investment’s performance and cost of broker services should be available in real time.

Wall Street’s sleight of hand

How retail brokers and wholesalers hide costs from investors.

The primary failure of the NMS is its failure to give retail investors knowledge of transaction costs that impact the value of retail investor portfolios This opacity makes brokers’ services impossible to evaluate.

Investors have no way to make an informed choice of a retail broker and no way to reward their broker for choosing an investor-friendly execution service from wholesalers and exchanges.

The blame for investor ignorance falls squarely on Wall Street. Wall Street has left the appearance that retail brokers have no way to show investors the quality of their filled orders.

The all-in cost of any customer transaction appears to be outside the retail broker’s knowledge and control. Retail brokers don’t know the insider-outsider bid-ask spread – the difference between the price wholesalers give to customers and the insider price which is available to wholesalers only.

The graphic below displays the NMS structure today.

Why don’t retail brokers capture the bid-ask spread between retail and insider prices themselves?

Why are retail brokers so magnanimous, so willing to share fat bid-ask spreads with wholesalers?

It is about appearances. Retail brokers cannot be seen to be arbitraging their retail order flow against their proprietary trades. Retail brokers need a middleman to “clean” the function of pricing retail orders below the market. Since brokerage fees are gone, retail brokers also need wholesaler payment for their retail orders.

Given the failure of SEC-approved exchanges to produce the best prices through retail broker choice of a single exchange, there is no doubt that wholesale broker-dealers are essential to the working of the NMS. Wholesalers are like sin eaters. Retail brokers use wholesalers to sin arbitraging retail investors’ outsider prices against the insider prices available to them. Then retail brokers accept payment for providing retail victims to wholesalers. Thus, the cost and the quality of wholesalers’ offers for order flow are unknown to retail investors.

But putting retail customers in direct contact with wholesalers is not the answer. Both wholesalers and retail investors gain from the middleman services of retail brokers – solicitation and bundling of customer orders. Thus, the chain from customer to retail broker to wholesaler to the NMS makes sense.

But in any system consistent with the mission of the SEC, customers must be assured that the chain from customer to NMS and back again is efficient (least cost, maximum return to retail investment funds).

Retail broker ignorance of the size of the insider-outsider spread could be eliminated if retail brokers did not use their ignorance as a kind of vow of chastity, giving investors the impression that retail brokers serve their interests, not those of Wall Street. But in fact, retail brokers are preserving Wall Street’s inflated bid-ask spread, in exchange for a piece of the action.

Payment for order flow

With hindsight, payment for order flow (PFOF) was an inevitable result of the goat rodeo created by 13 SEC-approved exchanges and dealer-owned colocated computers. Survival in this chaotic system required advanced trading algorithms to automate the search for positive spreads between retail order prices and insider prices.

High-frequency traders/wholesalers profit from buying orders from retail brokers to be filled at an outsider’s price and then laid off at an insider’s price.

Post-transaction information is also lost in OTC transactions

The key information – comparison of prices – provided to buyers in the usual competitive economic model is missing for a retail investor because much of the value of an investment is accrued after the transaction. The table below shows a break-out of the information investors need to choose their brokers and monitor broker performance.

Before the transaction, this information would be provided on a summary basis relevant to the trade type and the broker. After the trade, the customer could see the actual values in real-time. An example is displayed below.

Cost parameters on average for similar investments.

1. Payment from the wholesaler for retail orders
2. Wholesaler bid-ask spread
3. Share of income from investment inventories of securities and cash held by the retail broker and wholesaler

A retail investment leaves a portfolio of cash and securities in brokers’ custody behind it. The interest payments from holding these cash and securities balances sometimes go to retail and wholesale brokers without the investor’s knowledge.

A retail investor using a retail broker being paid for order flow by wholesalers knows the price and part of the income from holding the security but never the arbitrage from reversing the transaction. This opacity does not exist if the investor sees the entire flow of value, which is information available in exchange trading but not in OTC transactions.

Both the SMS and futures markets are closed systems that could easily provide investors with full information both before and after the trade. Retail brokers within the NMS cannot meet this standard due to the OTC wholesaler-retail broker link and the NMS’ complexity. However, the SMS could provide the information on any retail broker’s behalf.

Key ingredients to provide a useful service

Most retail customers do not want to receive a detailed description of the costs associated with using each of the many alternative ways to fill an order. Just as retail brokers are a valuable link in the retail transaction chain because they simplify the complexity of the transaction chain for otherwise preoccupied retail investors, retail investors need a source of simple summary measures of retail broker performance.

Information and profit incentive

The fix must be provided by an “honest broker.” A publicly held retail broker cannot be expected to publicly evaluate its performance relative to the competition since the information will sometimes result in customer defection and thus reduce broker profits.

Retail investors need a third party like the SMS to provide a routine measure of the investment efficiency of any broker for each specific investor relative to the competition. Ideally, the competitive performance of retail brokers can be measured with a few numbers produced regularly and then collected and provided by the SMS.

In a market structure containing more than 13 exchanges and dominated by OTC fills of retail orders, the regular release of a few numbers measuring retail broker performance relative to the competition is a lot to ask.

A third-party honest broker could provide this information which could easily be verified by the SEC.

The closest thing to an honest broker today is Vanguard, owned by its customers. The ideal firm to spur NMS-wide competition would be a customer-owned full-service market utility, providing both free access to other for-profit retail brokers and a retail brokerage service of its own.

The interesting question is whether this utility could provide comparative performance data in an investor-friendly form at no cost to customers. There is an incentive to do so since it would provide customers with instant information about the relative value of the utility’s “back-end” transaction services. Until imitated by the competition such a service would be a reason to choose the utility’s services above others.

How would an investor-owned transaction utility work?

This utility would have a zero-cost “front end” – an information service comparing the recent performance of customer-selected retail brokers in executing orders of a customer-specified type.

Three sources for investment services are compared in the analysis below.

1. An investor-owned retail broker, the SMS
2. A publicly held retail broker
3. A futures broker

Closed-loop transaction services like SMS and futures markets that have no OTC transactions as part of order filling could readily provide this information. Moreover, since the SMS is investor owned, there would be no reason not to provide competitors’ information as well. All sources of investment-based income that are usually hidden from retail customers would be easily provided for comparison with the same information provided by cooperating retail brokers.

The SMS has a captive wholesale broker-dealer, meaning that the SMS could readily provide bid-offer spreads that other retail brokers would need to collect from their independent wholesalers.

Given the front-end broker comparison, the customer could access either the utility’s “back end” full-service exchange/broker-dealer or another retail broker for order execution.

Post-trade information collection after a broker has executed a transaction has a cost of its own. Thus, investors will need to pay for it. The central facts of the utility’s cost and value of providing this information are these:

1. Brokers and dealers collect this information already to evaluate the profitability of their operations.
2. The release of this information to investors would alter the demand for retail brokers’ and wholesalers’ services.

On one hand, the information should be simple and easy for investors to interpret. On the other, it should not be misleading. Since the investor-owned SMS would be the first information provider, the incentive to provide easily interpreted information relevant to the investor’s future portfolio value is assured. Competitive pressure would then incentivize ordinary retail broker-dealers to provide similarly cogent information.

Conclusion

To simplify investors’ choice of transaction systems, investors need key information relevant to their choice of broker. Most importantly, investors would be able to determine the quality of their broker’s execution if they knew the bid-ask spread between the prices they receive and insider prices they cannot access.

This information would be readily provided at no cost by a full-service investor utility that offers all the functions of a securities market system under one roof, owned by retail investors. An investor-owned participant in all the functions a modern market provides would create the competitive alternative to the NMS needed to pry useful competitive information from for-profit brokers, dealers, and exchanges.