The Quarter-Penny Tick

Key Question Being Explored in This Insight:

How can the SEC's penny-based price variation rule help protect institutional traders from fast traders exploiting quote-matching strategies in the National Market System?

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Institution: University of Southern California

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How can the SEC’s penny-based price variation rule help protect institutional traders from fast traders exploiting quote-matching strategies in the National Market System?

Image courtesy of interviewee. October 31, 2024

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This video discusses the complexities and perceived inequities within the stock market, particularly focusing on how various pricing models and exchange practices can lead to the transfer of wealth from retail traders to hedge funds. It introduces the concept of "maker-taker" pricing, where the roles of traders are classified as "makers" (those who set prices) and "takers" (those who accept prices), with takers paying higher fees that are partially rebated to makers. This video creates a scenario where the market is not as equitable as many believe, leading to a loss of potential earnings for ordinary traders who are unaware of these financial nuances.

This video explains how new pricing models and regulations have evolved over the years, including changes that allow exchanges to collect fees differently, which can affect the apparent cost of trading. It also highlights the impact of high-frequency trading and how traders may leverage these market structures to their advantage. The discussion culminates in a critique of regulations set by the SEC that, while aiming to level the playing field, may in some instances complicate it further, thus continuing the cycle of wealth transfer and favoring more sophisticated traders who understand these dynamics.

Overall, the text raises concerns regarding the fairness of the trading environment, the lack of awareness among retail traders, and the regulatory challenges that persist in creating a truly equitable marketplace.

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Here are five key points extracted from the video:

1. **Unequal Market Dynamics**: The video explains that there are hidden mechanisms in the financial markets, specifically relating to how wealth is transferred from retail traders to hedge funds, creating an uneven playing field that many traders are unaware of.

2. **Tick Size and Trading Fees**: It discusses the concept of tick sizes, particularly the standard one-penny tick system. The author notes that despite the appearance of this structure, the effective economics of trading can lead to discrepancies in the actual cost of trades due to exchange fees and rebates.

3. **Maker-Taker Pricing Model**: The maker-taker pricing model is introduced, where "makers" (those who set the price) receive rebates, while "takers" (those who accept the price) pay fees. This model affects how traders experience market prices because makers can end up with a net benefit compared to takers.

4. **Inverted Exchanges**: The video describes inverted exchanges, which charge makers fees and offer rebates to takers. This results in buyers paying more on inverted exchanges compared to maker-taker exchanges, thus affecting traders’ choices and the overall market dynamics.

5. **Regulatory Changes and Challenges**: The author addresses recent regulatory changes by the SEC aimed at reducing trading fees and addressing the problems associated with maker-taker systems. However, the narrator believes that these changes do not fully solve the underlying issues and could even exacerbate the competitive disadvantage faced by retail traders.

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Here are some key quotes and important points extracted from the video regarding hidden wealth transfers in financial markets, exchange pricing models, and regulatory changes:

1. **Hidden Pipelines**:
- "There's a set of hidden pipelines that transfer wealth from retail traders to hedge funds, and people don't know about it."

2. **Unlevel Playing Field**:
- "The playing field is not a level playing field, and people don't know about that either."

3. **Market Perception vs. Reality**:
- "I wrote a paper to identify just how different the markets are from most people perceive them."

4. **Tick Size**:
- "Presently trades on a one penny tick... But in fact, the economics are different."

5. **Exchange Fees and Pricing Models**:
- "The reason they're different has to do with exchange fees and how exchanges collect their fees."
- "Recognize that exchanges are essentially just brokers. They match buyers to sellers."

6. **Maker-Taker Pricing**:
- "Under the maker taker pricing, what the exchanges do is they identify who was the maker."
- "In the maker taker pricing scheme, a good portion of that exchange fee is rebated to the maker."

7. **Rebate Mechanics**:
- "The net fee to the exchange is 5 cents a hundred shares. And if you trade a lot of shares, you make a lot of money this way."

8. **Inverted Exchange Structure**:
- "The secondary exchange... inverted the pricing."
- "If you trade at the maker taker exchange where you can't trade because you're last in line, you would've gotten 19.75."

9. **Market Dynamics**:
- "If you want to get ahead of the line, you're gonna have to bid 21."
- "Now your order's gonna trade first because the takers... they'd rather take at the inverted exchange."

10. **Regulatory Changes**:
- "The SEC just dropped... changes... the limit was 30 cents a hundred for taking fees."
- "The regulation just adopted is going to reduce the maximum that exchanges can pay, a hundred to 10 cents a hundred."

11. **Concerns About Market Equality**:
- "We're left with the interesting question, which is a strategy question."
- "There's still an advantage to stepping in front, and I find that concerning."

12. **Profiting from Market Structure**:
- "The hidden pipelines transfer a tremendous amount of wealth from traders who aren't taking advantage of them."

These quotes encapsulate the discussion about the complex mechanisms of trading fees, the advantages accrued by certain traders in the market, and the regulatory landscape that shapes these dynamics.

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There's a set of hidden pipelines that

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transfer wealth from, retail traders,

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to hedge funds.

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Uh, and people don't know about it.

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Uh, the playing field is not a level playing field,

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and people don't know about that either.

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And so I was quite concerned about this

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and wrote a paper to identify just

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how different the markets are from.

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Uh, most people perceive them, as most of our,

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viewers probably know.

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Uh, the stock market in the United States,

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presently trades on a one penny tick.

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That means that you can quote prices on pennies,

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but you can't quote prices on say, a half penny.

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Uh, that by the way, is changing.

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And, the, some of the changes are as a result

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of the paper that I wrote.

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But for right now, you can quote prices on,

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pennies.

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And so we say there's a one penny tick.

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So if price goes from 8 0 2

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and it moves up, it's gonna go up to 8 0 3, and,

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and going up by a penny is called moving up by a tick.

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Okay? Now, in fact, that's what the law says

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that you can only quote on,

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penny ticks on even pennies.

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But in fact, the economics are different.

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Uh, and the reason they're different has to do with,

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exchange fees and how exchanges collect their fees.

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And that's called maker taker pricing.

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And the inverse

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of it is called taker maker pricing, or inverse pricing.

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Recognize that exchanges are essentially just brokers.

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They match buyers to sellers.

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They're a special type of broker,

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and they're heavily regulated.

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But what brokers do is they match buyers to sellers.

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Historically, exchanges charged, fees

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for their services as they must, just as brokers do.

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They would charge the buyer a small fee,

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and the seller a small fee.

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Sometimes they would only charge the seller like we see in

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real estate in the United States.

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Um, and they collected their fees this way.

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But, with the advent of

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ECNs more than 20 years ago, in particular island,

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a new pricing model emerged.

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And that model was called maker taker pricing.

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And under the maker taker pricing,

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what the exchanges do is they identify who was the maker

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and who was the taker for every transaction.

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So now we need a little more background.

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So the maker is the trader who proposes, I'm willing to buy

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at say, 23 and a half.

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Uh, and somebody looks at that

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and says, gee, I'm willing to sell at 23 and a half.

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I'll take that price.

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So one person makes the price and the other one takes it.

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The maker can be on the buy side, as I just illustrated,

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or the maker can also be on the sell side

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where the maker says, gee, I'll sell for 30.02.

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Somebody looks at that and says, gee, that's a good price.

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I'll take it. And they end up buying it 30.02 For every

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trade, there's a maker, the trader who proposed the price,

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and the taker who says, I'll take that price

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so we can classify, this is what the, exchanges now do.

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They classify traders

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by whether they made the price or took the price.

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And in the maker taker pricing scheme,

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the taker pays a high fee,

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and a good portion of that exchange fee is rebated

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to the maker.

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It's a kind of a strange system here.

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And now you're beginning to see

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that there are some hidden pipelines.

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Um, so, as the law is presently

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set, the maximum taking fee,

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is three tenths of a cent per share.

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And the rebate typically is about,

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a quarter of a cent per share.

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Or we could call this, 30 cents,

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125 cents, a hundred rebate.

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Okay? Um,

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and, so the net fee to the exchange

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is, 5 cents a hundred shares.

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And if you trade a lot of shares,

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you make a lot of money this way.

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Um, okay, so,

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this represents a transfer of wealth from the takers

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to the makers, but it also means that the,

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maker

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who say is buying at 20 even

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is actually gonna get paid.

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Uh, let's see. So the maker is somebody who is,

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making the market.

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They're buying, they're proposing the price,

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so they're gonna get a rebate for doing that.

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So, while they're actually buying at,

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a quoted price of 20, with the rebate,

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let's assume that 20 is the penny portion of the price.

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So maybe it's, it's $50

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and 20 cents, we're just gonna call it 20.

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The rebate, of, half a cent means

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that they're actually buying at 1975.

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So 19 pennies

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and 75, a fraction, a three quarters of a penny.

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The price that they're actually receiving net

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is a little bit better because they're making market.

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And likewise, if they were making market on the sell side

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and they ended up selling, they would receive, say they was

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offering at 21, and they traded, they would trade at 21

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and a and a quarter.

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Okay? So now that, now the first thing we notice is

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that bid ask spreads are being affected by these fees.

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When we think about them in net terms,

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and that's a somewhat different story,

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and if you want later we can explain why the ECNs did this.

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But for right now, let's get to the question you asked is,

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where the hell is this, this quarter cent tick coming from?

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Okay, so at some point, about 10

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or 15 years ago, some very clever, exchange,

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companies, these are companies like NASDAQ

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or, New York,

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sibo, New York Stock Exchange.

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Um, they bought, other exchanges,

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and they, they're, now, these are

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exchange operating companies.

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They operate the New York Stock Exchange.

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They, they operate some exchanges people haven't heard of,

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like bats and, and others that people have heard of,

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but sort of forgotten, like the Boston Stock Exchange

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or the Philadelphia Stock Exchange.

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Well, they bought up these exchanges,

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and they changed the rules.

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So what they did is they created a set of rules,

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that said,

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we've got our primary exchange,

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and then we're also going to have an identical exchange

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that in every respect has the same rules, except

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that we're gonna collect fees differently.

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So, by the same rules, I mean, they match buyers

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to sellers using the same precedents rules.

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The guys who offer the highest prices go first,

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and the people who first offer those prices,

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they get matched first.

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Things like that. So the standard

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exchange at that point was now a maker taker exchange,

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as we just described, but the secondary exchange,

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or this other exchange,

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which we're now gonna call an inverted exchange,

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inverted the pricing.

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And what they did is they said, okay, if you, if you

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make a market, you're gonna pay for making a market.

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And if you take the market, then you're gonna get a rebate.

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So we're gonna, we're gonna pay you

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to come to this exchange.

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And now the fees here, if you are,

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making, they'll charge you,

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let me get this right, I

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wanna make sure I've got it right.

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If you are, let's do it on the, yeah, if you're making,

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they will charge you 25,

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cents a share, 25 cents, a hundred or,

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or a quarter of a cent per share.

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And if you are taking, they will rebate,

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20 cents a hundred.

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So I've got that one right. Now.

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Let's figure out if you are making at a,

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inverted exchange, what's your net price?

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So suppose you're buying at, 20 cents.

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Again, it could be, you know, 50 and 20 cents.

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Uh, but let's ignore the integer portion.

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You're buying it 20 cents,

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and, you now have to pay another quarter cent per share

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to,

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if your, bid is hit, if somebody takes your bid,

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and so your net price is now 20 and a quarter,

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and if it were on the other side and you're offering 21,

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and somebody takes your offer,

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then your net price is now going to be 1975,

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because you're going to have to pay, a,

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quarter to allow somebody to trade with you at,

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at, 20 cents.

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It sounds a little bit complicated,

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but we're almost at pay dirt.

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And here's how it works.

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Let's compare the prices,

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at the maker taker exchange with the inverted exchange.

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Suppose we have two buyers, both of whom are willing

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to buy at 20,

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and, that's exactly what they quote,

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and that's what the exchanges show

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the buyer at the make

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or taker exchange is gonna end up buying.

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If they get hit for 19.75 cents

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plus the integer portion, the buyer at the inverted exchange

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is gonna end up buying at 19

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and a quarter, I'm sorry, 20 and a quarter.

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They're both quoting 21 is gonna be a quarter cent below,

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and the other one's gonna be a quarter cent above.

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And so we can see that between those two exchanges,

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buyers at the

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inverted exchange are gonna pay a a half cent more than

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buyers at the regular maker taker exchange.

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Okay? So if you knew that you were gonna buy one way

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or the other, clearly you'd wanna buy at

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the maker taker exchange.

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Okay? So,

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00:11:43.805 --> 00:11:45.065
and let's, let's,

211
00:11:45.285 --> 00:11:47.785
add another interesting dealer, detail.

212
00:11:48.335 --> 00:11:49.665
Suppose you're a taker

213
00:11:50.085 --> 00:11:54.085
and you see that at both exchanges you have a 20 bid.

214
00:11:55.425 --> 00:11:57.115
Well, this is a no-brainer as well.

215
00:11:57.935 --> 00:12:01.475
If you take at the, inverted exchange,

216
00:12:01.575 --> 00:12:03.635
you're gonna get paid 20 cents a hundred

217
00:12:03.695 --> 00:12:05.515
shares for, for taking.

218
00:12:06.785 --> 00:12:09.685
And so you're gonna have to, you're, you're selling,

219
00:12:09.705 --> 00:12:10.725
of course, if,

220
00:12:10.725 --> 00:12:14.965
because the, the makers are buyers in this example.

221
00:12:15.865 --> 00:12:18.525
Uh, and if you're selling, you're gonna have to,

222
00:12:19.025 --> 00:12:21.405
you're gonna get, you're gonna get some money for the sale,

223
00:12:21.505 --> 00:12:23.485
but now they're gonna throw in a little extra money.

224
00:12:24.865 --> 00:12:29.845
But if you take at the standard exchange, again,

225
00:12:29.845 --> 00:12:31.725
you're gonna get 20 cents nominal.

226
00:12:31.725 --> 00:12:33.805
That's the quoted, but you're gonna have

227
00:12:33.805 --> 00:12:37.405
to pay the exchange if you are, taking,

228
00:12:38.685 --> 00:12:43.265
from a buyer at the standard exchange.

229
00:12:43.805 --> 00:12:45.745
So the buyer's bidding 20, which means

230
00:12:45.745 --> 00:12:46.865
that you're selling at 20,

231
00:12:46.965 --> 00:12:51.345
but you're going to have to pay the exchange,

232
00:12:51.345 --> 00:12:53.585
30 cents a hundred for this privilege.

233
00:12:54.125 --> 00:12:58.065
And so your net price is going to be, lower as a seller.

234
00:12:58.445 --> 00:13:01.825
So this, again, is another no brainer that clearly,

235
00:13:02.205 --> 00:13:04.625
if you get to choose which exchange you're going to,

236
00:13:04.685 --> 00:13:08.345
and you're going to be, taking the price,

237
00:13:08.845 --> 00:13:11.625
you're always gonna take it the inverted exchange first

238
00:13:12.115 --> 00:13:13.405
because it's better for you.

239
00:13:14.615 --> 00:13:17.705
Okay? Now, you and I are unaware of this,

240
00:13:17.705 --> 00:13:19.625
but our brokers are aware of it and they're doing it.

241
00:13:19.625 --> 00:13:21.065
We'll talk about that story later,

242
00:13:21.235 --> 00:13:24.225
where the quarter cent tick comes from.

243
00:13:25.235 --> 00:13:27.415
So now we're left with the interesting question,

244
00:13:27.495 --> 00:13:28.975
which is a strategy question.

245
00:13:29.035 --> 00:13:31.775
So maybe I am answering directly your question.

246
00:13:33.095 --> 00:13:35.195
Um, why would anybody

247
00:13:36.335 --> 00:13:39.395
bid at an inverted exchange or offer?

248
00:13:39.535 --> 00:13:42.475
So why would they make markets at these exchanges when

249
00:13:42.475 --> 00:13:44.155
they're gonna net pay more?

250
00:13:45.575 --> 00:13:48.195
And the answer is, goes like this.

251
00:13:50.635 --> 00:13:55.115
You wanna buy the market is 20 bid at a standard exchange,

252
00:13:56.105 --> 00:13:58.525
which is the maker taker exchange now,

253
00:14:00.005 --> 00:14:03.745
and you'd love to buy there because if you, you bid there

254
00:14:03.765 --> 00:14:05.585
and somebody hits your bid, you'll,

255
00:14:06.245 --> 00:14:08.985
you'll actually trade at 1975,

256
00:14:08.985 --> 00:14:13.035
which is better than 2019 0.75.

257
00:14:14.215 --> 00:14:16.675
But there's a long line of people who wanna buy there,

258
00:14:16.735 --> 00:14:19.555
and you can't, you'd like to be first in line

259
00:14:19.775 --> 00:14:21.035
and you just gotta wait.

260
00:14:22.785 --> 00:14:25.645
And so you'd like to, you'd like to trade quicker

261
00:14:26.235 --> 00:14:28.485
because perhaps you think prices are rising,

262
00:14:28.625 --> 00:14:29.725
but you don't want to go out

263
00:14:29.825 --> 00:14:32.525
and hit a hit the offer or something like that.

264
00:14:33.555 --> 00:14:36.045
Okay? So maybe the market's 20 bid

265
00:14:36.185 --> 00:14:38.885
and 22 offered or something like that.

266
00:14:40.025 --> 00:14:42.285
At that exchange, if you wanna get ahead of the line,

267
00:14:42.285 --> 00:14:45.085
you're gonna have to bid 21.

268
00:14:45.855 --> 00:14:49.795
And if you trade at 21, you're gonna get 20.75.

269
00:14:51.795 --> 00:14:54.695
But suppose you go to an inverted exchange

270
00:14:55.195 --> 00:14:58.015
and you say, I'm gonna bid 20 at the inverted exchange.

271
00:14:59.655 --> 00:15:02.905
Okay, so now you've got a 20 bid at the inverted exchange,

272
00:15:03.125 --> 00:15:05.425
and somebody else, maybe a lot

273
00:15:05.425 --> 00:15:08.785
of other people got 20 bids at the maker taker exchange,

274
00:15:09.685 --> 00:15:12.985
but now your trade is, your order's gonna trade first

275
00:15:13.495 --> 00:15:16.945
because the takers look at it as we just explained,

276
00:15:16.945 --> 00:15:20.065
and they, they'd rather take at the inverted exchange

277
00:15:20.345 --> 00:15:21.505
'cause they get paid to do it.

278
00:15:22.755 --> 00:15:25.135
And so you are gonna jump ahead of the line,

279
00:15:25.595 --> 00:15:27.055
but instead of jumping ahead

280
00:15:27.055 --> 00:15:30.485
and paying a full cent net,

281
00:15:31.365 --> 00:15:34.385
you're jumping ahead and only paying a half cent net

282
00:15:35.415 --> 00:15:38.545
because if you trade at the

283
00:15:39.775 --> 00:15:42.295
maker taker exchange where you can't trade

284
00:15:42.295 --> 00:15:46.695
because you're last in line, you would've gotten 19.75.

285
00:15:48.165 --> 00:15:51.185
If you trade at the,

286
00:15:52.265 --> 00:15:54.945
inverted exchange, you're gonna have

287
00:15:54.945 --> 00:15:56.425
to pay a quarter to do it.

288
00:15:57.265 --> 00:16:00.445
And so you'll end up paying 20.25.

289
00:16:00.705 --> 00:16:04.415
And the difference between the two is a half penny. Okay?

290
00:16:04.435 --> 00:16:07.055
So now we've established that there's a half penny spread

291
00:16:07.555 --> 00:16:09.615
and we know why people might do it.

292
00:16:10.605 --> 00:16:13.545
Now, you and I, if you trade with the right people,

293
00:16:13.645 --> 00:16:14.825
you might be able to do this.

294
00:16:15.865 --> 00:16:18.165
So for instance, if you trade

295
00:16:18.165 --> 00:16:20.725
through interactive broker, you can actually direct your

296
00:16:20.725 --> 00:16:22.005
order to where you want it to go.

297
00:16:23.195 --> 00:16:26.045
I'll reveal now that I'm the, lead independent director

298
00:16:26.045 --> 00:16:27.485
for interactive brokers.

299
00:16:27.505 --> 00:16:28.565
So when we talk about that,

300
00:16:28.785 --> 00:16:31.765
you should consider whether I'm promoting interactive

301
00:16:31.765 --> 00:16:33.765
brokers or in, or informing your audience.

302
00:16:34.185 --> 00:16:37.005
But in this case, I'm just stating what is.

303
00:16:37.005 --> 00:16:38.845
And there are other brokers where you can direct your

304
00:16:38.845 --> 00:16:40.725
orders, but most people don't do this.

305
00:16:41.345 --> 00:16:43.285
Uh, don't know. Um,

306
00:16:43.905 --> 00:16:47.605
and so, the high frequency traders who

307
00:16:48.025 --> 00:16:50.005
of course wanna buy at the lowest prices

308
00:16:50.185 --> 00:16:53.965
and sell at the highest prices like everybody else,

309
00:16:54.195 --> 00:16:56.165
they occasionally wanna trade quickly

310
00:16:56.585 --> 00:16:58.685
and are willing to pay for the privilege of doing it.

311
00:16:59.425 --> 00:17:03.325
And so they'll use these inverted exchanges to jump ahead

312
00:17:03.325 --> 00:17:04.925
of people like you and I.

313
00:17:05.155 --> 00:17:06.965
What we've established now is

314
00:17:06.965 --> 00:17:09.725
that the playing field isn't exactly level.

315
00:17:11.485 --> 00:17:14.095
Most of us think that we're playing on a field

316
00:17:14.095 --> 00:17:16.575
where the tick is a full penny,

317
00:17:17.455 --> 00:17:20.675
but in fact, the economic tick to the point

318
00:17:20.675 --> 00:17:22.755
that I've explained it right now is a half penny.

319
00:17:24.705 --> 00:17:27.485
And so, I can explain to you,

320
00:17:27.505 --> 00:17:30.085
and if we have time, we will explain

321
00:17:30.305 --> 00:17:32.485
how these guys profit from this privilege.

322
00:17:33.265 --> 00:17:37.005
But, but at a high level, it's really easy

323
00:17:37.065 --> 00:17:39.325
to see why they've got, why they will profit.

324
00:17:39.865 --> 00:17:42.125
And that's because they're playing on a playing field

325
00:17:42.125 --> 00:17:44.885
where they have more degrees of freedom to maneuver.

326
00:17:46.185 --> 00:17:48.685
And so, that gives them

327
00:17:48.745 --> 00:17:52.645
The option to do stuff that you and I basically don't do

328
00:17:52.705 --> 00:17:54.045
or can't easily do.

329
00:17:55.065 --> 00:17:58.045
And the ability to do what other people can't do

330
00:17:58.625 --> 00:18:01.125
in any game is an advantage.

331
00:18:01.865 --> 00:18:04.645
And it, of course, explains, for instance, in chess

332
00:18:05.185 --> 00:18:08.245
why the queen has more power than the rook or the bishop,

333
00:18:08.745 --> 00:18:11.955
because a queen can go on the diagonals

334
00:18:12.055 --> 00:18:16.355
or on the flats, whereas, the other two are restricted

335
00:18:16.355 --> 00:18:18.395
to their, specific domains.

336
00:18:19.335 --> 00:18:21.355
And so if you were playing on a board

337
00:18:21.355 --> 00:18:22.675
where you didn't have any queens

338
00:18:23.375 --> 00:18:27.875
and the other players did, you had a serious disadvantage.

339
00:18:28.255 --> 00:18:31.275
The SEC just dropped a,

340
00:18:31.275 --> 00:18:35.195
dropped they adopted is the right word, changes

341
00:18:35.335 --> 00:18:39.155
to reg NMS, NMS stands for the National Market System.

342
00:18:39.735 --> 00:18:44.315
Uh, this regulation, originally,

343
00:18:45.015 --> 00:18:49.555
established limits on how much the fees could be.

344
00:18:50.095 --> 00:18:53.795
Uh, so the limit was, 30 cents a hundred,

345
00:18:54.215 --> 00:18:55.355
for taking fees.

346
00:18:56.015 --> 00:18:57.475
Uh, and it established

347
00:18:57.475 --> 00:18:59.355
that you couldn't have sub penny pricing,

348
00:18:59.385 --> 00:19:02.355
that the quoted prices actually had to be on a penny.

349
00:19:03.455 --> 00:19:05.515
Uh, this was done about 20 years ago,

350
00:19:05.515 --> 00:19:08.275
and I was one of the principal architects along

351
00:19:08.275 --> 00:19:10.795
with a woman named Annette, Nazareth,

352
00:19:10.815 --> 00:19:14.115
who then headed the division of market rig when,

353
00:19:14.345 --> 00:19:16.515
when I was chief economist at the SEC.

354
00:19:17.415 --> 00:19:20.475
Uh, and we should note of course, that every success,

355
00:19:20.495 --> 00:19:22.275
and I believe that was a success at the

356
00:19:22.275 --> 00:19:23.555
time, had many, many parents.

357
00:19:24.055 --> 00:19:25.115
So it wasn't just us.

358
00:19:26.095 --> 00:19:27.835
Um, so they've, come

359
00:19:27.835 --> 00:19:29.955
around 20 years later to revise this.

360
00:19:30.255 --> 00:19:33.235
Uh, it's become apparent that at,

361
00:19:33.385 --> 00:19:34.875
that there are these problems

362
00:19:34.875 --> 00:19:37.355
with the maker taker markets, as I described.

363
00:19:37.975 --> 00:19:41.955
Um, we have, the half penny tick that I described.

364
00:19:41.955 --> 00:19:45.275
There's another exchange that does maker taker pricing,

365
00:19:45.775 --> 00:19:49.955
but they don't give a rebate for, making,

366
00:19:49.955 --> 00:19:51.515
they don't have charge a fee for making.

367
00:19:52.015 --> 00:19:55.275
And so that puts a, that's a quarter cent, above,

368
00:19:55.465 --> 00:19:57.915
it's a quarter cent between these two other types

369
00:19:57.935 --> 00:19:59.555
of exchanges, and that's

370
00:19:59.555 --> 00:20:01.275
where we get the quarter cent, tick.

371
00:20:02.255 --> 00:20:06.755
So, the, regulation just adopted,

372
00:20:06.935 --> 00:20:11.555
is going to reduce the maximum that exchanges can pay,

373
00:20:11.695 --> 00:20:16.555
or can charge for exchange fees, from, 30 cents,

374
00:20:16.635 --> 00:20:18.035
a hundred to 10 cents a hundred.

375
00:20:18.975 --> 00:20:23.395
So we'll still have inverted exchanges and, make

376
00:20:23.395 --> 00:20:26.315
or taker exchanges and this intermediate exchange as well.

377
00:20:26.895 --> 00:20:29.915
But now the tick sizes are gonna be reduced,

378
00:20:30.975 --> 00:20:32.475
but it doesn't eliminate the problem.

379
00:20:32.505 --> 00:20:36.155
There's still an advantage to step stepping in front,

380
00:20:37.095 --> 00:20:41.555
and, I find that, I find

381
00:20:41.555 --> 00:20:43.745
that, concerning.

382
00:20:44.525 --> 00:20:47.065
So with, with our remaining time, let's talk,

383
00:20:47.080 --> 00:20:49.325
talk quickly about the microeconomics of,

384
00:20:49.705 --> 00:20:52.925
of why stepping in fronts advantageous large order

385
00:20:53.065 --> 00:20:55.165
or, slow orders to buy at 20.

386
00:20:55.265 --> 00:20:56.925
And you see this and you say,

387
00:20:56.945 --> 00:20:58.365
Hey, I'll get in front of them.

388
00:20:58.475 --> 00:21:00.285
I'll buy at 20, and now,

389
00:21:00.835 --> 00:21:03.045
some small fraction like a 10th of a cent.

390
00:21:03.755 --> 00:21:07.885
Okay? And suppose I trade, okay, so now I've traded

391
00:21:08.225 --> 00:21:09.565
and now I'm in the market.

392
00:21:10.025 --> 00:21:12.965
If the market subsequently rises, I'm gonna make money.

393
00:21:13.745 --> 00:21:15.925
But if the market falls, I'm gonna turn around

394
00:21:15.985 --> 00:21:17.165
and I'm gonna very quickly,

395
00:21:17.485 --> 00:21:20.325
'cause I'm a very quick trader doing this, sell

396
00:21:20.325 --> 00:21:22.365
to those slower traders who are bidding at 20

397
00:21:23.325 --> 00:21:26.585
and I bound my losses at a 10th of a cent.

398
00:21:27.625 --> 00:21:30.885
So I've got lo gain potential gains that are

399
00:21:31.555 --> 00:21:32.925
unlimited on the upside.

400
00:21:33.545 --> 00:21:35.725
And if I'm quick enough, I can ensure

401
00:21:35.725 --> 00:21:37.085
that I won't lose more than a 10th

402
00:21:37.085 --> 00:21:41.425
of a cent under the new regulations, or a quarter of a cent

403
00:21:41.485 --> 00:21:43.425
or even a half cent as it used to be.

404
00:21:44.235 --> 00:21:48.085
Okay? So, this is an option that's valuable.

405
00:21:48.965 --> 00:21:53.185
Uh, and, what happens is the guy at 20 who

406
00:21:53.185 --> 00:21:56.465
otherwise would've traded if you didn't step in front

407
00:21:56.465 --> 00:22:00.465
of them, loses the opportunity to profit if prices rise

408
00:22:00.765 --> 00:22:02.985
and they end up losing a prices fall.

409
00:22:03.685 --> 00:22:07.705
And so they're in a situation where if they failed to trade,

410
00:22:07.705 --> 00:22:08.705
they wish that they did,

411
00:22:09.085 --> 00:22:11.185
and if they did trade, they wish that they hadn't,

412
00:22:11.435 --> 00:22:13.385
which is not a good way of making money.

413
00:22:14.565 --> 00:22:17.905
Uh, so that's the, that's how this strategy actually works,

414
00:22:18.005 --> 00:22:20.225
but we already know it in the abstract

415
00:22:20.345 --> 00:22:23.745
because give people more privilege, they're gonna find a way

416
00:22:23.745 --> 00:22:24.745
to use it and make money.

417
00:22:25.685 --> 00:22:30.065
So the SEC has acted to, reduce,

418
00:22:30.415 --> 00:22:31.785
this problem to some extent,

419
00:22:32.745 --> 00:22:34.105
although frankly, they've made it bigger

420
00:22:34.105 --> 00:22:35.265
because they've made it cheaper

421
00:22:35.365 --> 00:22:36.745
to step in front of other people.

422
00:22:38.165 --> 00:22:41.065
Um, they also are acting the,

423
00:22:41.125 --> 00:22:46.015
the new reg is gonna give us a half penny quoted tick,

424
00:22:47.565 --> 00:22:52.425
for, actively traded stocks that are presently have bid

425
00:22:52.425 --> 00:22:54.065
as spreads of, of just a penny.

426
00:22:55.185 --> 00:22:59.285
Uh, so I think they did some of what's right, but not all.

427
00:22:59.945 --> 00:23:03.525
In a perfect world, I would've gotten rid of all of these

428
00:23:04.085 --> 00:23:05.565
maker take fees,

429
00:23:07.845 --> 00:23:10.145
and I would have,

430
00:23:11.685 --> 00:23:14.785
if you want a smaller tick size, okay, that fine.

431
00:23:15.085 --> 00:23:17.945
But let the exchanges collect commissions

432
00:23:18.045 --> 00:23:19.185
as they always did.

433
00:23:19.765 --> 00:23:20.865
The world won't end.

434
00:23:22.205 --> 00:23:23.585
It works really well elsewhere

435
00:23:23.585 --> 00:23:24.985
where people don't use this model.

436
00:23:25.285 --> 00:23:27.585
It worked really well before we had this model,

437
00:23:27.965 --> 00:23:29.745
and the economics are just obvious.

438
00:23:29.805 --> 00:23:31.385
So it, it's not, there's not a danger.

439
00:23:31.725 --> 00:23:36.105
But these hidden pipelines transfer a tremendous amount

440
00:23:36.105 --> 00:23:40.785
of wealth from, traders who aren't taking advantage

441
00:23:40.805 --> 00:23:42.945
of them because they're losing the

442
00:23:42.945 --> 00:23:44.225
option value of their orders.

443
00:23:45.145 --> 00:23:49.605
And that wealth goes to the, clever traders who are able

444
00:23:49.605 --> 00:23:51.045
to exercise the strategy.

445
00:23:52.065 --> 00:23:55.485
And that wealth gives those, clever traders the ability

446
00:23:55.545 --> 00:23:59.485
to lobby their senators who write letters to the SEC asking,

447
00:23:59.585 --> 00:24:00.925
why would you change the market

448
00:24:01.035 --> 00:24:03.965
that is working better than any other market in the world?

449
00:24:05.025 --> 00:24:07.725
My answer to that, of course, is,

450
00:24:07.905 --> 00:24:10.625
we wanna make the markets better,

451
00:24:10.655 --> 00:24:13.205
even better, and they can be.

452
00:24:14.065 --> 00:24:15.565
But the SEC sees that

453
00:24:15.565 --> 00:24:18.445
and says, Hmm, our hearings about

454
00:24:18.795 --> 00:24:21.525
what our budget's gonna be next year is next month.

455
00:24:22.025 --> 00:24:24.205
And the guy who just wrote this letter is on

456
00:24:24.205 --> 00:24:25.325
that, on that committee.

457
00:24:25.905 --> 00:24:29.165
So maybe we don't push it as much as we'd really like to.

458
00:24:29.725 --> 00:24:32.605
I think the SEC knows what they, what they should be doing,

459
00:24:33.145 --> 00:24:35.165
but, what they should be doing

460
00:24:35.185 --> 00:24:38.325
and what they can do is limited by political realities.

461
00:24:38.665 --> 00:24:40.845
And so you try to do the best that you can.

462
00:24:41.145 --> 00:24:43.645
And if the world doesn't end with these changes,

463
00:24:43.865 --> 00:24:46.285
as it surely won't, then the next time they revisit,

464
00:24:46.295 --> 00:24:48.525
maybe they'll get to what we, where we need to be.

Hidden Wealth Transfers in Trading Markets

00:00:00 - There's a set of hidden pipelines that transfer wealth from, retail traders, to hedge funds. and people don't know about it. the playing field is not a level playing field, and people don't know about that either. And so I was quite concerned about this and wrote a paper to identify just how different the markets are from. most people perceive them, as most of our, viewers probably know.

00:00:37 - presently trades on a one penny tick. That means that you can quote prices on pennies, but you can't quote prices on say, a half penny. that by the way, is changing. And, the, some of the changes are as a result of the paper that I wrote. But for right now, you can quote prices on, pennies. And so we say there's a one penny tick. So if price goes from 8 0 2

00:01:09 - and going up by a penny is called moving up by a tick. Okay? Now, in fact, that's what the law says that you can only quote on, penny ticks on even pennies. But in fact, the economics are different. and the reason they're different has to do with, exchange fees and how exchanges collect their fees.

Understanding Maker-Taker Pricing in Exchange Markets

00:01:38 - And the inverse of it is called taker maker pricing, or inverse pricing. Recognize that exchanges are essentially just brokers. They match buyers to sellers. They're a special type of broker, and they're heavily regulated. But what brokers do is they match buyers to sellers. Historically, exchanges charged, fees for their services as they must, just as brokers do. They would charge the buyer a small fee,

00:02:08 - Sometimes they would only charge the seller like we see in real estate in the United States. and they collected their fees this way. But, with the advent of ECNs more than 20 years ago, in particular island, a new pricing model emerged. And that model was called maker taker pricing. And under the maker taker pricing, what the exchanges do is they identify who was the maker

00:02:41 - So now we need a little more background. So the maker is the trader who proposes, I'm willing to buy at say, 23 and a half. and somebody looks at that and says, gee, I'm willing to sell at 23 and a half. I'll take that price. So one person makes the price and the other one takes it. The maker can be on the buy side, as I just illustrated, or the maker can also be on the sell side

The Dynamics of Maker-Taker Pricing in Trading

00:03:16 - Somebody looks at that and says, gee, that's a good price. I'll take it. And they end up buying it 30.02 For every trade, there's a maker, the trader who proposed the price, and the taker who says, I'll take that price so we can classify, this is what the, exchanges now do. They classify traders by whether they made the price or took the price. And in the maker taker pricing scheme,

00:03:46 - and a good portion of that exchange fee is rebated to the maker. It's a kind of a strange system here. And now you're beginning to see that there are some hidden pipelines. so, as the law is presently set, the maximum taking fee, is three tenths of a cent per share. And the rebate typically is about,

00:04:20 - Or we could call this, 30 cents, 125 cents, a hundred rebate. Okay? and, so the net fee to the exchange is, 5 cents a hundred shares. And if you trade a lot of shares, you make a lot of money this way. okay, so, this represents a transfer of wealth from the takers

Understanding Maker-Taker Pricing and Its Impact on Market Trades

00:04:53 - maker who say is buying at 20 even is actually gonna get paid. let's see. So the maker is somebody who is, making the market. They're buying, they're proposing the price, so they're gonna get a rebate for doing that. So, while they're actually buying at,

00:05:25 - let's assume that 20 is the penny portion of the price. So maybe it's, it's $50 and 20 cents, we're just gonna call it 20. The rebate, of, half a cent means that they're actually buying at 1975. So 19 pennies and 75, a fraction, a three quarters of a penny. The price that they're actually receiving net

00:05:55 - And likewise, if they were making market on the sell side and they ended up selling, they would receive, say they was offering at 21, and they traded, they would trade at 21 and a and a quarter. Okay? So now that, now the first thing we notice is that bid ask spreads are being affected by these fees. When we think about them in net terms, and that's a somewhat different story, and if you want later we can explain why the ECNs did this.

Origins of the Quarter Cent Tick

00:06:27 - where the hell is this, this quarter cent tick coming from? Okay, so at some point, about 10 or 15 years ago, some very clever, exchange, companies, these are companies like NASDAQ or, New York, sibo, New York Stock Exchange. they bought, other exchanges,

00:07:00 - exchange operating companies. They operate the New York Stock Exchange. They, they operate some exchanges people haven't heard of, like bats and, and others that people have heard of, but sort of forgotten, like the Boston Stock Exchange or the Philadelphia Stock Exchange. Well, they bought up these exchanges, and they changed the rules. So what they did is they created a set of rules, that said,

00:07:33 - and then we're also going to have an identical exchange that in every respect has the same rules, except that we're gonna collect fees differently. So, by the same rules, I mean, they match buyers to sellers using the same precedents rules. The guys who offer the highest prices go first, and the people who first offer those prices, they get matched first. Things like that. So the standard

Understanding Inverted Exchanges and Market Pricing

00:08:05 - as we just described, but the secondary exchange, or this other exchange, which we're now gonna call an inverted exchange, inverted the pricing. And what they did is they said, okay, if you, if you make a market, you're gonna pay for making a market. And if you take the market, then you're gonna get a rebate. So we're gonna, we're gonna pay you

00:08:35 - And now the fees here, if you are, making, they'll charge you, let me get this right, I wanna make sure I've got it right. If you are, let's do it on the, yeah, if you're making, they will charge you 25,

00:09:05 - or a quarter of a cent per share. And if you are taking, they will rebate, 20 cents a hundred. So I've got that one right. Now. Let's figure out if you are making at a, inverted exchange, what's your net price? So suppose you're buying at, 20 cents. Again, it could be, you know, 50 and 20 cents. but let's ignore the integer portion.

Understanding Price Dynamics in Inverted Exchanges

00:09:35 - and, you now have to pay another quarter cent per share to, if your, bid is hit, if somebody takes your bid, and so your net price is now 20 and a quarter, and if it were on the other side and you're offering 21, and somebody takes your offer, then your net price is now going to be 1975,

00:10:11 - quarter to allow somebody to trade with you at, at, 20 cents. It sounds a little bit complicated, but we're almost at pay dirt. And here's how it works. Let's compare the prices, at the maker taker exchange with the inverted exchange. Suppose we have two buyers, both of whom are willing

00:10:41 - and, that's exactly what they quote, and that's what the exchanges show the buyer at the make or taker exchange is gonna end up buying. If they get hit for 19.75 cents plus the integer portion, the buyer at the inverted exchange is gonna end up buying at 19 and a quarter, I'm sorry, 20 and a quarter.

Comparative Analysis of Exchange Pricing: Maker-Taker vs. Inverted Exchange

00:11:14 - and the other one's gonna be a quarter cent above. And so we can see that between those two exchanges, buyers at the inverted exchange are gonna pay a a half cent more than buyers at the regular maker taker exchange. Okay? So if you knew that you were gonna buy one way or the other, clearly you'd wanna buy at the maker taker exchange.

00:11:43 - and let's, let's, add another interesting dealer, detail. Suppose you're a taker and you see that at both exchanges you have a 20 bid. Well, this is a no-brainer as well. If you take at the, inverted exchange, you're gonna get paid 20 cents a hundred shares for, for taking. And so you're gonna have to, you're, you're selling, of course, if, because the, the makers are buyers in this example.

00:12:19 - you're gonna get, you're gonna get some money for the sale, but now they're gonna throw in a little extra money. But if you take at the standard exchange, again, you're gonna get 20 cents nominal. That's the quoted, but you're gonna have to pay the exchange if you are, taking, from a buyer at the standard exchange. So the buyer's bidding 20, which means that you're selling at 20,

Understanding Inverted Exchange Benefits

00:12:51 - 30 cents a hundred for this privilege. And so your net price is going to be, lower as a seller. So this, again, is another no brainer that clearly, if you get to choose which exchange you're going to, and you're going to be, taking the price, you're always gonna take it the inverted exchange first because it's better for you. Okay? Now, you and I are unaware of this,

00:13:19 - We'll talk about that story later, where the quarter cent tick comes from. So now we're left with the interesting question, which is a strategy question. So maybe I am answering directly your question. why would anybody bid at an inverted exchange or offer? So why would they make markets at these exchanges when they're gonna net pay more? And the answer is, goes like this.

00:13:56 - which is the maker taker exchange now, and you'd love to buy there because if you, you bid there and somebody hits your bid, you'll, you'll actually trade at 1975, which is better than 2019 0.75. But there's a long line of people who wanna buy there, and you can't, you'd like to be first in line and you just gotta wait.

Navigating Exchange Strategies: The Advantage of Inverted Markets

00:14:26 - because perhaps you think prices are rising, but you don't want to go out and hit a hit the offer or something like that. Okay? So maybe the market's 20 bid and 22 offered or something like that. At that exchange, if you wanna get ahead of the line, you're gonna have to bid 21. And if you trade at 21, you're gonna get 20.75. But suppose you go to an inverted exchange

00:14:59 - Okay, so now you've got a 20 bid at the inverted exchange, and somebody else, maybe a lot of other people got 20 bids at the maker taker exchange, but now your trade is, your order's gonna trade first because the takers look at it as we just explained, and they, they'd rather take at the inverted exchange 'cause they get paid to do it. And so you are gonna jump ahead of the line,

00:15:27 - and paying a full cent net, you're jumping ahead and only paying a half cent net because if you trade at the maker taker exchange where you can't trade because you're last in line, you would've gotten 19.75. If you trade at the, inverted exchange, you're gonna have to pay a quarter to do it.

Unequal Trading Fields: Understanding the Half Penny Spread

00:16:00 - And the difference between the two is a half penny. Okay? So now we've established that there's a half penny spread and we know why people might do it. Now, you and I, if you trade with the right people, you might be able to do this. So for instance, if you trade through interactive broker, you can actually direct your order to where you want it to go. I'll reveal now that I'm the, lead independent director for interactive brokers.

00:16:28 - you should consider whether I'm promoting interactive brokers or in, or informing your audience. But in this case, I'm just stating what is. And there are other brokers where you can direct your orders, but most people don't do this. don't know. and so, the high frequency traders who of course wanna buy at the lowest prices and sell at the highest prices like everybody else, they occasionally wanna trade quickly and are willing to pay for the privilege of doing it.

00:17:03 - of people like you and I. What we've established now is that the playing field isn't exactly level. Most of us think that we're playing on a field where the tick is a full penny, but in fact, the economic tick to the point that I've explained it right now is a half penny. And so, I can explain to you, and if we have time, we will explain

Unequal Advantages in Trading: The Power of Flexibility

00:17:33 - But, but at a high level, it's really easy to see why they've got, why they will profit. And that's because they're playing on a playing field where they have more degrees of freedom to maneuver. And so, that gives them The option to do stuff that you and I basically don't do or can't easily do. And the ability to do what other people can't do in any game is an advantage.

00:18:05 - why the queen has more power than the rook or the bishop, because a queen can go on the diagonals or on the flats, whereas, the other two are restricted to their, specific domains. And so if you were playing on a board where you didn't have any queens and the other players did, you had a serious disadvantage. The SEC just dropped a, dropped they adopted is the right word, changes

00:18:39 - this regulation, originally, established limits on how much the fees could be. so the limit was, 30 cents a hundred, for taking fees. and it established that you couldn't have sub penny pricing, that the quoted prices actually had to be on a penny. this was done about 20 years ago,

Regulatory Revisions and Market Pricing Concerns

00:19:08 - with a woman named Annette, Nazareth, who then headed the division of market rig when, when I was chief economist at the SEC. and we should note of course, that every success, and I believe that was a success at the time, had many, many parents. So it wasn't just us. so they've, come around 20 years later to revise this. it's become apparent that at, that there are these problems with the maker taker markets, as I described.

00:19:41 - There's another exchange that does maker taker pricing, but they don't give a rebate for, making, they don't have charge a fee for making. And so that puts a, that's a quarter cent, above, it's a quarter cent between these two other types of exchanges, and that's where we get the quarter cent, tick. So, the, regulation just adopted, is going to reduce the maximum that exchanges can pay,

00:20:16 - a hundred to 10 cents a hundred. So we'll still have inverted exchanges and, make or taker exchanges and this intermediate exchange as well. But now the tick sizes are gonna be reduced, but it doesn't eliminate the problem. There's still an advantage to step stepping in front, and, I find that, I find that, concerning.

Microeconomic Strategies in Trading: The Advantage of Stepping In Front

00:20:47 - talk quickly about the microeconomics of, of why stepping in fronts advantageous large order or, slow orders to buy at 20. And you see this and you say, Hey, I'll get in front of them. I'll buy at 20, and now, some small fraction like a 10th of a cent. Okay? And suppose I trade, okay, so now I've traded and now I'm in the market. If the market subsequently rises, I'm gonna make money. But if the market falls, I'm gonna turn around

00:21:17 - 'cause I'm a very quick trader doing this, sell to those slower traders who are bidding at 20 and I bound my losses at a 10th of a cent. So I've got lo gain potential gains that are unlimited on the upside. And if I'm quick enough, I can ensure that I won't lose more than a 10th of a cent under the new regulations, or a quarter of a cent or even a half cent as it used to be. Okay? So, this is an option that's valuable.

00:21:53 - otherwise would've traded if you didn't step in front of them, loses the opportunity to profit if prices rise and they end up losing a prices fall. And so they're in a situation where if they failed to trade, they wish that they did, and if they did trade, they wish that they hadn't, which is not a good way of making money. so that's the, that's how this strategy actually works, but we already know it in the abstract

Regulatory Challenges in Trading Fees and Market Fairness

00:22:23 - to use it and make money. So the SEC has acted to, reduce, this problem to some extent, although frankly, they've made it bigger because they've made it cheaper to step in front of other people. they also are acting the, the new reg is gonna give us a half penny quoted tick, for, actively traded stocks that are presently have bid

00:22:55 - so I think they did some of what's right, but not all. In a perfect world, I would've gotten rid of all of these maker take fees, and I would have, if you want a smaller tick size, okay, that fine. But let the exchanges collect commissions as they always did. The world won't end. It works really well elsewhere

00:23:25 - It worked really well before we had this model, and the economics are just obvious. So it, it's not, there's not a danger. But these hidden pipelines transfer a tremendous amount of wealth from, traders who aren't taking advantage of them because they're losing the option value of their orders. And that wealth goes to the, clever traders who are able to exercise the strategy. And that wealth gives those, clever traders the ability

Navigating SEC Constraints: Improving Market Dynamics

00:23:59 - why would you change the market that is working better than any other market in the world? My answer to that, of course, is, we wanna make the markets better, even better, and they can be. But the SEC sees that and says, Hmm, our hearings about what our budget's gonna be next year is next month. And the guy who just wrote this letter is on that, on that committee.

00:24:46 - I think the SEC knows what they, what they should be doing, but, what they should be doing and what they can do is limited by political realities. And so you try to do the best that you can. And if the world doesn't end with these changes, as it surely won't, then the next time they revisit, maybe they'll get to what we, where we need to be.

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