It is a question that many (I hope) will have asked themselves when trading on the financial markets, today I would like to ask it again: what do financial intermediaries really do?
It may seem like a simple concept but believe me that it is much more complicated than it seems, I hope to give you a different view of the financial markets but in particular between our workstation and the market.
There are two types of intermediaries:
– The broker acts as a pure intermediary
– Dealer is a “masked” broker who acts on his own behalf towards a potential client
These channels track the economic compensation that these institutional subjects receive to direct the flow of orders of their clients to exchanges or market makers.
This is the general definition, now I would like to go into the details of these procedures that are not always as clear as they make us believe that a service sells us.
Intermediary usually receives small earnings to direct orders to a particular market maker, do you agree that there is a first conflict of interest?
The answer is yes, for the options market makers are the masters because stocks could have thousands of existing contracts and order flow payment is the basis for transactions we are talking about less than 50 cents for each contract.
Do you remember Bernard Madoff? I help you in 2008 he was one of the biggest scammers in the history of the United States, there is talk of losses close to 65 billion dollars, who knows in Palm Beach how happy his golf “friends” were…
Bernard Madoff introduced payment for order flow so this should make you understand that it is a non-transparent system at the base.
Who is a market maker?
Market maker is a large company that maintains an inventory of derivative contracts (options for example), shares etc … and offers them to both a buyer and a seller, here is the bid / ask that you see on the books and this is their gain, so the more trades on both sides there will be the more the market maker will earn money.
Since 2005 Security Exchange Commission requires financial intermediaries to inform customers if they receive payment for sending orders to the market to specific market makers, in essence you have to calculate that the larger the company the more it will have the ability to handle more orders at lower prices while a small brokerage firm may have a benefit of channeling orders to certain market makers and earn compensation.
Translation of the concept, when you want to open a trading account the first step to do is to negotiate with the financial intermediary the commissions, this is the first rule a bit like if you have a cheese shop and clearly you will have to negotiate with suppliers to get the best price.
When you see companies that offer transactions at no cost, be very careful, why? Do you know anyone in life who works for free? During the lockdown, don’t you remember that a “case study” emerged on companies that sold the flow of orders to companies that trade high frequency?
It is true that high frequency traders provide liquidity to the market but to understand this phenomenon read my previous articles, unfortunately the SEC has not blocked this procedure of payment of the flow of orders to increase competition among market makers avoiding the monopoly of exchanges. It is also true that the SEC wanted to ask financial intermediaries to disclose the conditions with market makers, I am referring to rule 605 and 606.
Rule 605 requires “market centers” trading National Market System securities to make available standardized monthly reports containing statistical information on the execution of “covered orders.”
Rule 606 requires broker-dealers who route client orders into stocks and options to make quarterly reports publicly available that identify the locations to which client orders are routed for execution. In 2020 there was a change because brokers were required to provide net payments received each month from various market makers on transactions executed on S&P 500 stocks.
A real business was born for commissions (apparently free) through the diversion of the order flow to market makers with the disadvantage of the investor who is not always served in the best market conditions.
For those who do or want to make trading a daily job it is essential to know both the costs of commissions and if the financial intermediary does the interests of customers or market makers, I am aware that it is difficult to understand some dynamics but the goal of this article is to open people’s eyes.