Investors Should Worry More About Payment for Order Flow than HFT

Long gone are the days of the buttonwood tree.  On May 17th, 1792, twenty- four brokers gathered on Wall Street under a buttonwood tree and signed the document that would establish the guidelines for buying and selling stocks and bonds, and held members to adhere to a 0.25% commission rate.  Deals were done with handshakes, not high speed computers.

Buttonwood Tree from Museum of the City of NY

Wall Street Brokers Under the Sycamore Tree – Source: Museum of the City of New York

Things must have gotten a little crazy over 200 years, because by the time I started in the business at Dean Witter in the early 1990’s, we collected several hundreds of dollars in commissions for small stock trades (um, most of which the company kept, I received only about 1/4).  Then along came one of my heroes, Charles Schwab, who had railed against high fees and was instrumental in the deregulation of commissions which was mandated by the Securities and Exchange Commission in May of 1975.  The mandate eliminated high fees and allowed lower cost providers such as Schwab to force market competition to set commission rates.  By the time I was working at Schwab in 1995, online trading was launched, driving down commissions.  Technology has revolutionized the stock markets, and expanded access that was previously limited to exclusive groups.

In 2004, Schwab sold its capital markets business to UBS and, as part of that agreement, sends the majority of stock trades (known as “order flow”) to UBS.  In exchange, UBS pays Schwab.  Over 90% of orders are sent to UBS from Schwab to be fulfilled (see link below for details).  In his 2000 testimony to the Senate Banking Committee, Schwab himself stated “I worry…about payment for order flow” and went on to explain that Schwab continued the practice due to competitive pressures (see the full testimony below).  Firms like Schwab, E*Trade and TD Ameritrade bring in hundreds of millions of dollars every year from this practice, enabling them to offer low commissions to their retail customers.  The proliferation of trading drove down commissions, but forced firms to seek out revenue in other areas.

This is what enables financial firms to also offer what appear to be ridiculously low-cost Exchange Traded Funds and Index Funds.  How could a fund with expenses below 0.25% be a sustainable business model for an investment company?  Investors are paying the price elsewhere.  We may see an upheaval with respect to this, because it affects a huge aspect of the markets – the expanded ETF market and mutual funds held in 401(k) plans.  If you have investments in a 401(k), it is likely that the fees are quite high, you just don’t necessarily see that despite recent legislation to improve disclosures.

The real issue is this: how can investors truly know what they are paying so they can objectively evaluate their after cost returns on an annual basis?  This issue of excessive fees and a lack of transparency has always lit a fire under me, and led to my launching of the Pawleys Dividend Fund and Pawleys Growth Fund, two privately offered funds organized under Rule 506 of Regulation D.  My advisory fee is 0.75%, and I publish the holdings to all investors to ensure complete transparency, as any shareholder can audit the performance.

Online trading added unprecedented volumes to the stock markets, and as commissions dropped firms worked to find revenue in other places.  In the meantime, they leveraged the public loathing of high commissions and fees, and cleverly built this into their marketing of “low cost” investments.  Low cost does not equate to performance.   There are many great choices for investors that offer reasonable expenses and solid performance.  Establish a procedure where you evaluate the after-cost performance of your investments versus the appropriate benchmark.  For those who are lured by the discount broker advertisements that say you can make money trading (bumping up the commissions and payments they receive for order-flow), you can, if you learn about technical analysis and enter with a specific trading strategy.  Scalping and front-running are two practices that disadvantage investors and are prohibited (it is like someone taking money from you or cutting the line in front of you).  These practices existed long before HFT came along.

If you are truly worried about HFT and how they are rolling in the dough, take a closer look at what happened to Knight Capital.  Knight, based in New Jersey, used HFT algorithms and was the largest trader in U.S. equities until an accidentally released set of code led to the company taking a loss of almost $500 million and their downfall.  So much for HFT.

© 2014 Pawleys Investment Advisors, LLC. All rights reserved.

Schwab Order Routing:

Testimony to Senate Banking Committee:


Please Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s