PFOF and Bernie Madoff
Not that long ago Bernie Madoff passed away, in recent years he was infamous for running one of the largest and most brutal financial Ponzi scheme scams the world has ever seen. This particular Ponzi scheme ran for a very long time because the economy was running hot enough during this time to enable a stream of enough new money flowing into the scam to keep the scam running. While people love to demonize him now it's very interesting, and depressing, to note that before this scam was revealed the financial media actually held him in fairly high regard. Madoff was a founding board member of the Depository Trust & Clearing Corporation subsidiary in London. The DTCC is a very important part of how the modern stock markets settle trades (especially international ones), we will come back to the DTCC in a bit. People like Harry Markopolos had fairly comprehensive proof that a major fraud was being perpetrated but really most people just didn't care, the money was still rolling in and the Madoff scam hadn't become infeasible due to cashflow issues yet. Something I came across the other day was an interview with CNN money which suggests that developments in the Payment for Order Flow (often referred to by the acronym PFOF) space were actually Bernie Madoff "innovations".
The way in which trades are actually executed on the main stock exchanges is far more complex and opaque than most people realize, if you want to know some of the details about the plumbing I'd recommend reading this article about the DTCC and how this is important in the process of how many trades clear. There's some interesting points in this article that many people are unaware of, specifically how trades can actually take a few days to get settled and in the interim most trades that look "instant" are really just being traded on margin until the the trades go through the DTCC after which point the actual title of the shares will be moved. In any case the way the markets really work isn't the way that many retail investors think they do. Occasionally things go wrong and all the plumbing that is so carefully hidden from everyone day to day blows up in everyone's faces1 like what happened with the GameStop Short squeeze in 2021, where platforms started limiting the ability of people to buy shares but not to sell them due to various issues with the financial plumbing. This left many retail traders surprised and angry because they were operating under the false assumption that their trades were being executed instantly on the stock market. That such a misconception exists at all should be no surprise since these apps and brokers have invested a huge amount of effort in their marketing and UI/UX design to give the appearances that trades happening on their platforms are instant even when this wasn't the reality. In between someone clicking some buttons on an app and the transfer of title (if this even happens, which sometimes it does not2) there's a lot of financial "plumbing" that actually matters a lot and this process is far from instant (and these delays matter for a number of reasons). One such way in which the details of the "plumbing" is relevant is that it makes strategies like Payment For Order Flow possible. This is the practice of selling the data about the trades your customers want to make to other parties before those same orders get filled/executed on the main stock exchanges.
Thinking about this more I can see how a firm that was running an investment scam might be involved with something like PFOF. After all the trading data for customers of a firm is just another thing you can profit off, even if you aren't actually executing the trades that you say you are, because the customer intent is still valuable data to someone else. In the linked interview from before Madoff claims "Whoever holds limit orders has an information advantage. But there are very strict rules that I would assume most firms comply with", which I find very interesting to reread now given his proven track record of acting illegally and unethically in the markets.
When you understand how PFOF works it is just about impossible to see the practice as anything other than a blatant conflict of interest. The fact that it's somehow still legal to have a platform engaged in PFOF without having to explicitly disclose this to the customers is still a slight surprise to me, but I guess most people have no idea PFOF even exists and therefore policymakers are still lagging behind. This reminds me of how I was surprised that insider trading using nonpublic government data in commodities used to be perfectly legal, so I guess these things can change over time, but people need to know how things really work for anything to change.
Perhaps importantly PFOF is a crucial factor that made the whole boom in retail "zero fees" app-based investing possible. Brokers like Robinhood3 offer zero commission trades to their users, the catch? Those users pay with their data about limit orders and various other trading data being shared with specialized trading firms (amongst other things). This data is incredibly valuable.
We saw examples of this with the IPO of Snowflake and a few other companies in 2020. Looking at how this information is used via an example perhaps illustrates what's going on most effectively. Imagine you run a brokerage, you know which stocks your customers are are willing to purchase and have information about limit orders that your customers want you to fill. Say that currently a popular stock is priced at $20 and they've just released a surprising press release while the market is closed with information that they are going to put cryptocurrency into space, they have appointed the Dogecoin dog as the CEO and they have a cure for cancer. Everyone now wants the stock, the FOMO is extreme and people just want to buy buy buy! A huge number of your customers start putting in limit orders in to purchase the stock at any price up to $50, if you are trying to exploit your "customers" as a broker how could you do this? One way is that you could sell this trade data to another firm before filling the orders and the other firm could then buy the stock at amounts less than $50 to then immediately sell it to your customers at the $50 price point that they have indicated they will pay and you then split those profits with the other firm that's doing the front running trade. If you have information about how big the gap in prices are this is potentially very lucrative. It is however very nasty for the people who use the platform to execute the trades because the real customers are the high frequency traders. As is often the case in the modern world if you aren't paying for the service you are the product.
I'd much rather pay a $30 fee on a trade than get a $30/share worse deal because my trade data was leveraged against me. Basically I'd rather be the client for a broker rather than the product and I'm happy to pay for the service of getting my trades executed the way I want. The difficulty broadly speaking is that fees are very obvious but the costs of worse trade execution are very explicitly designed to be anything but obvious. Unfortunately with the huge numbers of uneducated and financially ignorant piling into stock market speculation lately I suspect that many will think that the "free" execution on their trades is actually the better deal.
Honestly the huge amount of hidden complexity in the modern markets that is "abstracted away" from the average person is just enormous. It really reminds me of a lot of what goes on in the world of tech and computing where there's a tremendous amount of complexity that's hidden when things are going right and obvious only when things are going wrong. The markets much like a number of areas in tech can create this interesting psychological bias where people feel more confident that they know a higher proportion of knowledge in a domain than they really do when they go through good stretches where things work correctly. This is because in these good stretches many of the things you would could about are more invisible due to the abstracted nature of them and the process of discovery of these topics takes deliberate effort instead of being pushed upon you. ↩
Sometimes there is no exchange of title and what is really done is that a contract for difference contract is created for the client that gives them some exposure to the price movement of the underlying security without them actually owning it. I've met multiple retail traders who have thought they have had purchased stocks that they actually have no title over. ↩
The name of the broker just strikes me as Orwellian. I can't help but think of what they do but framed in terms of these old folk stories, you have this character Robin Hood who's gone off to fight in the crusades and he gets back to his town and the Sherif has taken the land. He's pissed off so he sides with the poor, but he has a chance encounter with Baron Madoff who suggests that maybe hew can make some extra cash by selling out the secrets of the poor to the highest bidder... I mean it just doesn't have the same feel to it when you corrupt the spirit of the old story this badly. ↩