February 4, 2010
In order to attract orders from brokers to use their trading venue, some exchanges will pay your broker's firm a penny or more per share for routing your order to them. Payment for order flow is one of the ways your broker's firm can make money from executing your trade. An ethical question arises in that the firm is getting a rebate and then turning around and charging the investor a commission or a fee, essentially doubling their payment. The SEC approves this practice as long as it is disclosed to the customer on the, AFTER the trade, on the confirmation. By then, the firm has couped the rebate and the commission.
Playing the rebate has become a new platform of trading for hedge funds. Hedge funds are currently developing new superior access, hardware and software to essentially fix the system in an attempt to earn in-house the rebates offered by the exchanges. Hedge funds advanced algorithms will do this all day long, with investor money, in order to provide or offer liquidity as this is how the rebate is earned. These firms are putting their interests ahead of all customers, whether retail or institutional. Where is the value added to the investors? Whatever happened to obtaining the best price for their customer?
This regulation has opened the door to flash orders. Flash orders allow high frequency traders to gain access to trading information before it is sent out widely to other traders. The exchange will flash the order for just a few fractions of a second before the information is publicly available. These traders, using super-fast computer can then act on that early information to trade ahead of pending orders. This front-running accounts for billion in profits.
This is all reminiscent of the NASDAQs Small Order Execution System (SOES) of the last decade. Firms were created just to take advantage of SOES just as firms are being designed today to skim the pennies off the publics savings and retirement account. There is high profitability and the current rebate system is bringing back the SOES bandit in the disguise of the hedge fund.