Ex options MM / hedge fund manager / HFT guy here.<p>This is a really good article.<p>The net interest thing has a parallel in the HF world. CTAs, a type of hedge fund, used to do substantially the same thing. The margin requirement for holding a load of futures is quite low, but the customers of the fund have put cash into the fund. So back when interest rates were higher, a fair bit of a CTA's returns would be interest on the cash.<p>He's right about Robinhood. From the HFT side, the problem is if you're in the "real" institutional market, someone will run you over occasionally. With retail, that never happens, and the spread you can offer is thus tighter. There's no front running to it, just the ease of non toxic flow. So RH is trying to put forward zero comms as a way to get some deposits.<p>He's also right about options. It's tempting to think that you can just sell some options to collect premium, or do a combination of some sort (iron condors, butterflies, etc) to save yourself from wasting money. But keep in mind the costs when you're doing this, and the fact that you are simply paying up to squish some risk into an unfamiliar shape. It also has a gambling-like tendency to create occasional wins to keep you interested.<p>As for investment advice for retail people, if you are a coder there doesn't seem to be any reason to use anyone other than IB. They are the cheapest, and if you can code you can use their APIs to trade whatever it is you want. I'm not saying anyone can make a great trading strategy, but you can certainly manage some passive investments with barely any fees. Or just take advantage of RH and do it free I suppose.
I honestly think there's an opportunity to create a YouTube channel that literally does nothing more than explain how X makes money, whether it's a VC firm, a Subway franchise, a toothpaste manufacturer, etc.<p>As someone with an entrepreneurial tick but not someone who's gone all in it would be so helpful to have edu videos that just explained the basic business model of XYZ.
Wow - first time I see some decent writing on the stock broker business, HFT, internalization. Good article...<p>What I would add to the article:<p>> Roboadvisors are a bad business below scale.<p>I would say that roboadvisors are just a bad business. Theyve been around for a decade+ and we haven't really seen any large robos created from the concept. I think this is because ETFs effectively capture or can capture what Robos do. And we will continue trending towards that. In that way, you can encapsulate the benefits of Robo (div reinvestment, tax gains, target date strategies) within an ETF without having to move your money out of your current brokerage account.<p>Also note that roboadvisors cant just do "robo". Today they are branching off into a dozen different services - so they look more and more like the traditional platforms.<p>> And then there’s Robinhood, which is a discount brokerage whose marketing and product decisions probably do not assist their users in achieving successful outcomes.<p>Yes - Robinhood is a gambling platform. Shameful IMHO but creates a field day for the owners and for internalizers/HFT folks.
Almost all of the discussion around payment for order flow is inaccurate. To highlight the worst,<p>1. Retail order flow is toxic like all other flow and trading against it blindly leads to material losses. Retail is particularly well informed with respect to news and major market events. "Retail investors destroy value when trading" is a fun quote and repeated assertion of the article, but is not true of any retail order flow I've seen (and I have seen all of it).<p>2. Wholesalers make surprisingly little money from the flow being uninformed. Most of the P&L is a result of (a) fee arbitrage (some strategies that aren't possible on public markets become possible with an internalizer because there are less market access fees), (b) queue priority (internalizing a market order allows the market maker to effectively rest at the inside without quoting there), and (c) strategies for executing special order types that cannot be traded against on exchanges (stops, for example).<p>3. Robinhood earns more for order flow because their order flow is less toxic (less informed) than other brokerages. It has nothing to do with options.<p>4. Retail order flow data is incredibly valuable since it's needed to build pricing and trading models. Citadel Securities, in fact, does run models (and machine learning models) against retail trade data and would not be profitable without it.<p>Finally, if wholesalers are good for retail investors is an open question that won't be answered by this blog piece. A simple thought exercise: if I'm a retail investor with the most aggressive limit order in the market and a market maker internalizes a retail market order on the opposing side -- is the result net good, or net bad for the two retail participants?
Having worked in the industry (at a defunct brokerage with well known commercials featuring the owner/CEO in a purple helicopter), I would say this is a fairly accurate description of the industry's economics. Just like most topics in the financial world, the general public is left in the dark regarding the specifics...articles like this help shed a small light.<p>*Updated spelling
Possible correction to the essay: I believe in this hypothetical you were actually supposed to be giving me one hundred dollars:<p>> "Suppose I were to give you a dollar... You’d earn $2.26 in net interest in a year."
<i>Suppose I were to give you $100, in return for your promise to give it back when I wanted it and pay me 0.27% annualized interest in the meanwhile. Suppose you invested this in a virtually riskless bond, perhaps a mortgage-backed security with government backing, offering 2.53% annualized interest. You’d earn $2.26 in net interest in a year.</i><p>You would also bear the risk of me wanting my money back before the security matures, at a time when its price is less than you paid for it.<p>A better example would be if you invested it by lending on an overnight inter-bank market, which is virtually risk-free, but gives you the option to stop lending at any time. You could make something like 2.38% in fed funds [1] or GC repo [2], so the argument still stands.<p>[1] <a href="https://apps.newyorkfed.org/markets/autorates/fed%20funds" rel="nofollow">https://apps.newyorkfed.org/markets/autorates/fed%20funds</a><p>[2] <a href="https://www.newyorkfed.org/markets/treasury-repo-reference-rates" rel="nofollow">https://www.newyorkfed.org/markets/treasury-repo-reference-r...</a>
Not sure what his point of including IB in there was? They are very up front about pretty much everything. Not sure you can find better than benchmark-50bp on cash balances and for accounts with larger balances they have a program in place to get you a little bit better.<p>Also, its really on the account holder to manage their cash balances. Most brokers allow you to do t-bills at auction for no charge, durations are as short as 4 weeks. You can also (at higher risk) usually find a floating rate fund they handle for no commission, FLOT or FLRN or simiilar.
Matt Levine on Robinhood and payment for order flow:<p><a href="https://www.bloomberg.com/opinion/articles/2018-10-16/carl-icahn-wants-to-fight-dell-again" rel="nofollow">https://www.bloomberg.com/opinion/articles/2018-10-16/carl-i...</a>
The shareholder letter from IB CEO Thomas Petterfly regarding the risks of HFT is quite interesting. (Page 14 <a href="https://investors.interactivebrokers.com/download/2018-IBG-AR.pdf" rel="nofollow">https://investors.interactivebrokers.com/download/2018-IBG-A...</a>) and copied partially below:<p>Trading against HFTs and institutions taking liquidity is generally not profitable, at least in the short run. As a consequence,
market participants are reluctant to place limit orders and the NBBO (the National Best Bid or Offer, or the highest limit
order to buy and the lowest limit order to sell) becomes wider.<p>HFTs are obligated to fill the orders they buy inside the NBBO to the extent of the size displayed. The wider the NBBO
becomes, the more discretion an HFT has as to the price at which it fills the order and, therefore, the more profit it makes
and the more it can then afford to pay for these orders.<p>The more HFTs pay for retail orders, the more brokers will sell their orders to HFTs and, consequently, even fewer orders
will trade at the exchanges in a competitive market. Also, the more payment the brokers receive for their customers' orders,
the more they can discount the commissions they charge their customers. Hence the newly emerging zero commission
brokers. However, the customer is likely to lose more on the execution price than she saves on the commission.<p>This is a self-reinforcing feedback loop in which wider markets cause even wider markets, increasing payment for orders,
moving more volume off the exchanges. Indeed, while in 2008 26.6% of the listed stock volume traded off the exchanges,
by 2018 36.3% of the volume traded off exchange.<p>What is the predictable consequence?<p>Liquidity vanishes.<p>Momentum traders drive the markets to more extreme highs and extreme lows in shorter periods of time.<p>Investors holding margin accounts become less able to liquidate, adding to the price swings.<p>This is a disaster waiting to happen.<p>While all of us in the trading and investment community have in one way or another adapted, and would prefer to let things
continue along the status quo, we cannot pretend that all is well the way it is.<p>We must implement structural changes to the markets before it is too late.
patio11, if you're reading this, any chance you can comment further on Interactive Brokers? I've used them, along with Schwab, Fidelity, and Merrill Edge. From what I've read, IB used to have better execution than the rest, but now it seems like Schwab and Fidelity, at least, have caught up.<p>Is there any <grinning because I know this and the rest don't> reason why a savvy user would prefer to use IB in 2019 over the others? I know they have ultra-low margin interest rates, a linked debit card, and a share lending program, but am I missing anything? Are there particular tax-avoidance techniques one can use with IB's building blocks? I'd love to know more!
I really like this article, although I don't fully understand most of the parts, mainly because I don't know much about brokerage and investment. But, I am joining the workforce soon, and it behooves me to have some grasp on these topics. Any non-Michael Lewis type book(s) you fine people would want to recommend?
I’d love to see the same treatment on discount auto insurers and large apartment realty groups and basically every other business that is actually about float.
> A discount brokerage is not a full-service brokerage, which used to charge several hundred 1970s dollars to place a single stock trade and which used to call you to convince you of the desirability of paying them several hundred dollars to place a single stock trade.<p>The implication (by the choice of words here) 'call you to convince you of the desirability of paying them several hundred dollars to place a single stock trade' implies incorrectly that retail brokers were not in some way able to earn that money by providing value. If that were the case they would not exist and money would flow elsewhere. That is if in the end the client did not feel they were getting value.<p>Not everything out there is better DIY or even close to that. Some people actually don't want to search for hours figuring out the best place to travel or which airline flight to take or city to go to. They'd rather pay a travel agent or someone else to do that for them. Just because the masses do not have money to pay for advice does not mean that that advice is not of clear value to someone else who is situation differently financially.<p>This is actually a problem in the computer business. People (en masse) free advice at no charge what others used to get paid to do. Some people actually just want a solution to a problem. They are not interested in doing it themselves, following tutorials or having to depend on some person being nice and not charging them for a solution.
I love IB but their API sucks, you have to run TWS or the gateway with manual 2 factor login. Anyone managed to improve on that? I'd like to get account and market data from code running on the cloud.
> you should be monomanically focused on the interest spread between cash balances in brokerage accounts and high-interest bank accounts or money market funds. That is the cost that does not call itself a cost.<p>If you're keeping a large cash balance sitting uninvested in your brokerage account, sorry but that's on you.
Patrick is brilliant, as always. This piece is particularly brilliant, and I wish he will elaborate more on it in the future:<p>> Some people get mad about the financial industry for taking advantage of customers. I find it hard to get mad about a deal between willing counterparties, but if you think that Wall Street is soaking the US middle class, you should be monomanically focused on the interest spread between cash balances in brokerage accounts and high-interest bank accounts or money market funds. That is the cost that does not call itself a cost.
Somewhat tangential, but I hope someday we can move more towards having stocks trade regularly but not on microsecond timescales. All of the fragmented liquidity being exploited by HFT is not a net economic gain. The exchanges already have an auction process to set opening and closing prices. Just run the same auction process every 10 minutes allowing liquidity to pool.
How do you use Wealthfront if living abroad? Their FAQ states that they require a permanent US residential address.<p>Also unclear to me whether Interactive Brokers transparently moves funds to brokerage accounts domiciled in your new jurisdiction, triggering FATCA filing requirements, and if they do a good job of making these clear to customers.
Here's some good advice I wish I had earlier. At least I think this is good advice. Tell me if I'm wrong.<p>You need to maximize your IRA. Why? Because you can trade within your IRA without tax-consequences. Buy low and sell high. After selling keep the cash around until things go down again and it's time to buy.
> Suppose I were to give you $100, in return for your promise to give it back when I wanted it and pay me 0.27% annualized interest in the meanwhile. Suppose you invested this in a virtually riskless bond, perhaps a mortgage-backed security with government backing, offering 2.53% annualized interest. You’d earn $2.26 in net interest in a year.<p>How would you rectify the duration mismatch between the on-demand deposit (of $100) with the multi-year mortgage-backed security?<p>For example, if the rate of interest increases, my $100 — that you invested in bonds — will now be worth less than $100 (since the price of the bond has fallen). How will you be able to honor my withdrawal when you’re insolvent?
Just dropping this thought off : patio11 just got himself and this article a nice write up on Matt Levine's Bloomberg newsletter (its v good too)<p>But what I realised is that patio11 must have spent many days researching this and writing it up, then published it and it frankly it looks like "real" journalism.<p>in fact it is, real journalism<p>But it's not packaged like it. So for all the talk about death of newspapers etc, it is possible for someone who is not a journalist, and not paid like one, to do the work - maybe we will see citizen journalism ?
> Brokerage customers keep ~10% of their assets in cash. The 200 basis point spread between cash in brokerage accounts and money market funds or insured bank accounts [...] is equivalent to a 20 bps asset management fee across the portfolio.<p>Could someone break this down a bit more? I'm trying to grok the point, but don't have the intuition. Where is the "200 basis point spread" coming from? Why is it equivalent to a 20 bps management fee?
I use a discount brokerage in Canada called Questrade. I keep as little cash as possible in my account (contributions and dividends get used within a few days to buy more ETFs), and my portfolio is entirely ETFs. If I also pay no commissions when issuing buy orders, how does the brokerage make money from me? Apart from the fees for order placement, is there interest earned for short-sellers borrowing ETFs?
I would be very interested to know which online brokerages cater to US expats — @patio11 seems to have experience with this.<p>In general, any advice and pointers about brokerages/banks/insurance for US expats from an actual expat would be immensely valuable. The googlable stuff is mostly fluff and SEO crap.
Had to look up internalizer (was a bit unclear): <a href="https://jwg-it.eu/defining-systematic-internaliser-under-mifid-ii" rel="nofollow">https://jwg-it.eu/defining-systematic-internaliser-under-mif...</a>
but otherwise a good read.
> Some people get mad about the financial industry for taking advantage of customers. I find it hard to get mad about a deal between willing counterparties, but if you think that Wall Street is soaking the US middle class, you should be monomanically focused on the interest spread between cash balances in brokerage accounts and high-interest bank accounts or money market funds. That is the cost that does not call itself a cost.<p>I'm grateful for this insight provided by the article. As someone interested in the takes on inequality presented by thinkers like Piketty, Stiglitz and McChesney, I think it's important to consider the fact that ultimately, the public good will remain hamstrung by the fact that those with the greatest know-how to create returns on investment are also those with the greatest profit-driven motivations. The middle class gets to choose between getting fleeced by brokerage fees, getting fleeced by the low rates of return offered by the banks, or getting fleeced by your own ignorance and lack of access to the infrastructure to generate market returns in the adversarial world of modern finance.<p>UBI and higher taxes I don't think can solve this problem, because as more and more of the market's growth is captured (extracted?) by the monoliths of private sector, who in a globalized world are not beholden to any one nation (just look at the effect of Brexit on Britain's financial sector), individual governments no longer really have the jurisdiction and leverage to capture enough of the market's return.<p>In the past I have been quick to blame stuff like the repeal of Glass-Steagall and other bipartisan deregulation efforts, as well as the dangerous assumptions of competence behind stuff like Black-Scholes and the Harry Markowitz approach, but ultimately I can't see any way around the fact that the profit motive just seems to be the greatest available driver of financial competence. What can even be done beyond impotently hoping for Gates Foundation-style philanthropy? Maybe the Chinese are actually ahead of the game with their State capitalism approach, and moving forward we should just all turn our governments into fintech companies with a side hustle of providing public infrastructure and services to the citizenry...
> since “retail investors destroy value when trading” is about as citation-needed as “smoking causes lung cancer” at this point<p>I mean, it could be a confounding variable that’s causing cancer in smokers. We haven’t exactly run randomized control trials in humans to clearly show causation.<p>The correlation sure is strong though.
Anyone knows what is meant by:<p>"(Again, hate to belabor a point, but Wealthfront charges 25 bps all-in (on top of the underlying ETFs) and every customer knows it"?
Sorry I have troubles understanding.<p>I gather the main money maker is "net interest" - but wouldn't that only apply if the Discount Broker sold me an investment (promising me x% in returns, while they make x+y% by reinvesting my money)? I thought that is exactly what Discount Brokers are not doing, I thought they only help me buy other people's investment vehicles?<p>Or is it just the cash I have sitting at the Discount Broker, to be ready to trade, that produces the gains for the Broker (average 10% according to the article)?<p>Or do the DBs usually offer "savings accounts" with interest x on your money, and all the other stuff (cheap stock trades and so on) are supposedly only the advertising, luring in customers so that you can send them offers?<p>"high-interest bank accounts" - where can I get such a one, or do they only exist for very rich entities, or only in the US?
I am absolutely <i>winning</i> by my generations standards. I own a home and have little doubt, no student loans, and health insurance that my doctor envies. I can only read articles like this wistfully imagining having some sort of "disposable income" for investments.<p>The best long term familial/genetic survival strategy for a large and growing segment of the population is social and economic collapse. Factor that into your investment plans. I <i>wish</i> I could...