It’s no surprise the Access Fee Pilot proposal has received comments from all over the industry, it represents a dramatic shift in the decades old philosophy of incentivizing market quality, and could affect spreads and depth across the market cap spectrum.
The comments below talk about the real reason behind the pilot and what it is trying to fix. Hint: it’s all about routing economics.
How do Algos and Routers Work?
Large trades have almost always been “worked” as a series of smaller pieces so they have less impact.
These days, institutional investors work most of their trades using sophisticated broker algorithms.
Those algorithms use a variety of posting strategies to minimize signaling and spread costs, as well as trading costs. How they send each slice into the market is mostly known as routing.
Routers have a lot of choices to make for every single order. There are around 50 venues, some lit and some dark, using marketable or limit prices, speed bumps and even conditional trading. Plus the economics of each venue are different, adding explicit costs to the impact and signaling costs.
Most routing choices are a trade-off between impact cost and the probability of fill. It is a choice between taking what you see now, or waiting, and sometimes hiding, in the hope of saving a penny (or less).
However waiting sometimes has a cost. If you don’t get the price you were looking for you might end up paying even more. When that happens there is an opportunity cost. We demonstrate how routing, and opportunity cost, works in the diagram below:
Click image to see full-size version
How can you Compare the Cost of Routing Decisions
We’re not going to pretend that this is easy – but you can garner some insight from an academic study that computed the costs of this “waiting game” for passive, lit, orders routed to different exchanges (the last four rows of the diagram above).
They did this by running “horse races”. The academics compared two identical orders resting at the bid, one in an “inverted” versus “maker taker” venues.
Inverted venues pay incentives to liquidity takers whereas maker-taker venues pay incentives to liquidity providers. Not surprisingly, what they found is that the cheaper-to-take (inverted) orders typically got filled first. Over time they also found that sometimes the maker-taker order missed fills at that limit price and had to chase prices higher. They had quantified an opportunity cost of being more patient. We show this in the diagram above as the difference between the green and blue routing strategies.
In essence, given opportunity cost is the cost of doing something different, you could quantify this yourself by running a simulation, or an A/B test, of the alternate strategy you didn’t do.
What about the Benefit?
Few would argue that best execution should account for all the costs of trading. The benefit of the more patient route is that some, or maybe all, of the opportunity cost may be offset by the incentives paid to liquidity providers resting in the maker-taker venue.
The problem, as the academics highlighted, is that those incentives are paid directly to brokers – and the academics assumed that the brokers would keep them all. That ultimately led to the SEC’s proposed Access Fee Pilot – which is designed to change market structure specifically to reduce the agency conflict that brokers have with respect to routing and investor queue priority.
So what are the Cost Benefit of the Access Fee Pilot?
This is a good question. We’re not aware of anyone that’s done that calculation.
The costs could be large – and some are predictable – from brokers retooling for another complex pilot, to institutions paying more for liquidity, to worse market quality in thinly traded stocks potentially even harming the IPO market.
The benefit is basically the “better fills” that institutional investors will get after the pilot is introduced. We’ve been trying to quantify this, but it’s difficult, and likely overstated.
- For a start, institutions who are affected by the conflict represent only 20% of all trading
- Plus most of their lit routes have no opportunity cost
- Although a lot of the routes with opportunity cost are dark routes, which are excluded from the pilot.
- That’s complicated by the fact that urgent investors can’t wait as long to capture spread and rebates, giving them different optimal routing.
- Which is further complicated by higher priced stocks, which have much less opportunity cost and, sometimes it seems, inverted venues lose horse-races and also signal more.
- Finally, the broker dealer market is competitive, potentially all of the costs of routing are offset by lower commissions, made possible by rebates collected.
Being data driven is important. Work is progressing on institutional 606 rules. But we highlight that those new reports will only show routing patterns and fulfillment by venue.
Data required to quantify routing costs already exists, we don’t need a pilot for that. Traders using it are not only aware of where their orders are routing but also what they need to change to improve their costs.
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