Ep 16: What Are Dark Pools, PFOF and Market Makers?

Jessie: A listener slash friend of mine sent me that John Stewart episode on the problem with stocks and he was talking about payment for order flow and dark pools and I realized I don't know what any of those things are or how they work. And I think you told me that part of your job in the past was educating clients on those sort of things, right?

Jess: You know how we talked about zero commissions back on episode one? technological progressions in like cost cutting to be able to have operating efficiencies really within the market and the way that works. So we need to talk about what happens to your order, what a market maker is, what a wholesaler is and how dark pools work. Let's talk about that. That'd be fun. Jessie: Greetings, money mermaids, merthems, and mermen. You are listening to Market MakeHer, the self-directed investor education podcast breaking down complex stock market topics from ‘her’ perspective. We're your host. I'm Jessica Inskip, the resident finance expert with 15 years of industry experience here to explain all of those complex topics.

Jessie: And I'm Jessie DeNuit, your siren guide on this financial empowerment adventure. asking all the questions you were thinking, so you don't have to.

Jess: Yes, and if you didn't notice, it's October special Halloween themed fancy dress episode. Jessie: Were we dressing up today? I didn't even think about that. Sorry, I'm just kidding.

Jess: We are also so thrilled and wanna thank every single one of our listeners, our community and for your support. We won gold for the Signal Awards.

Jessie: Yes. And we were the only finance podcast to do that, right?

Jess: Yeah, we were. And actually everybody in the best emerging podcast category got gold, so we're all winners. But I went through everyone that I saw in finance and no one got a gold award. So yeah, yay us.

Jess: Yeah, that's right. And congrats to all the other winners as well. And thank you to every single one of you that voted for us. We really, really appreciate it. Yes, thank you.

Jessie: Oh, where's mine?

Jess: Right, that would have been a good idea.

Jessie: Good man, I know. Should I? Oh, babe. Oh my God!

Jess: No way!

Jessie: James got Jess one too!

Jess: That was not planned.

Jessie: That was amazing. Thank you, baby.

Jess: There is, that is no, did James text her? Did they do it?

Jessie: Did James message you? No, they just both did it.

Jess: Aw.

Jessie: That's amazing.

Jess: Well cheers, Jessie. Cheers! Well that was great. I love that we both got hand-hand champagne at the same time. Here's one for financial literacy, bridging the investing gap. Yes. Speaking of financial literacy though.

Jessie: How are we gonna approach this probably huge topic without going down too many crazy rabbit holes today? Where are we gonna start?

Jess: We need to start with understanding how orders are displayed. NBBO.

Jessie: The what? Wait, say that one more time.

Jess: National bid and best offer.

Jessie: Okay. Is that an acronym I'm assuming?

Jess: Yes, NBBO. When you have a quote for a stock, we talked about the last price and the last price is? Is?  

Jessie: The last price the last time the stock was traded and it happens a bunch of times throughout the day. So when you log in, you look at the stock quote, it's the last price that it was just previously traded at. Right?

Jess: Perfect. Boom. Yeah, absolutely. Pull up a quote for Apple, pull up a quote for Microsoft, whatever, that price that you see, that's the last price. It's past tense. It has happened post execution. So when we're talking about the national bid and best offer, that's pre execution. So we're talking about price display and the market is an auction place, right? You are buying at the best available price. So the lowest someone is willing to sell something to you at, and you're selling at the best available price, which is the highest someone is willing to buy it at. And that's reflected on the bid and ask and actually pull up a stock quote so you can see a bid and ask. We're going to pull up a stock quote for Apple symbol AAPL prices are as of the close today, October 10th, 4pm Eastern time. The last price is $178.39 was down 60 cents. that is just the last time it traded, which is at market close, 4 p.m. Eastern time, right? If you look at the bid and the ask though.

Jessie: Hold on, where it says bid times size and ask time size?

Jess: That's right.

Jessie: Okay.

Jess: And that size is the amount of shares attached to that order, but it always is multiplied times 100. So that means there are 100 shares available at 178.45 to buy.

Jessie: Oh, okay.

Jess: Whatever price you see for the ask though, should be a higher price than the bid.

Jessie: It's like a few cents higher.

Jess: Exactly. So you buy on the ask, that's the lowest that someone is willing to sell you those shares. If you were like haggling, trying to get a bargain and someone's selling you an item and you're a buyer, if you've ever been in like a flea market, you know, where you're like, Hey, will you give me this for that? This is the lowest price that the seller, the other person of that trade, and that could be an individual or it could be the exchange and it could be a wholesaler. It be a lot of different things, but that is the best available price for you to buy across the entire market. That's what the ask is.

Jessie: Okay.

Jess: The bid is just the opposite. Those are full of buy orders because you're going to sell there. That is the highest that someone is willing to buy those shares at because you want to sell at the highest price possible. So it's the highest buys. The market is so regulated. The snapshot in time where the bid and ask is, the second you hit submit order. you are required to be filled within the bid and the ask. It cannot be outside of that.

Jessie: So who's getting, so for me, if the bid price is $178.41 and the ask is $178.48, who's getting that seven cents?

Jess: That would be a market maker or a wholesaler.

Jessie: So market makers and wholesalers are the same thing?

Jess: They are very similar, yes. And this is what's so important about understanding the functions of a market maker and even why we chose our name. So they are going to make sure that these prices that are displayed, they're going to make a market in it. They are responsible for price equality, no matter what. So you actually have to stay true to your word. You display a bid or ask, you're staying true to your word and you are making a market. That's what that means.

Jessie: Okay. I mean, it sounds like it's in the name again. how we always say it's literally the name they're making the market. What like fair?

Jess: Yeah, what we just described is called the top quote. That's a level one quote. There's a level two, which is kind of the back of it. If I were to pull up a level two quote for you right now, you would see the ask and remember it's always the lowest ask. So you would see a bunch of higher sells right behind it. So meaning if there were a lot of buys that go into the market all of the sudden, the ask is gonna get higher and higher and higher. And that's what pushes the stock market up in price because there's more buyers.

Jessie: Because it's demand, right?

Jess: Exactly.

Jessie: There's more demand.

Jess: Exactly.

Jessie: Okay.

Jess: Exactly. And that's important to know. when we talk about dark pools a little bit later on. So just keep that little nugget.

Jessie: When we talk about what? Dark pools?

Jess: Yes, dark poles.

Jessie: Where sirens live? Just kidding. Yes. We'll hold that thought. But the bid and the ask, the difference of those two, that's called the spread. And the market maker keeps the spread. It's all in the name. It's the spread as in like the width between the two prices, the price for you to buy and sell at. And as... a retail investor or any investor, not just limited to retail, when we're buying on the ask, it's always slightly higher than where we're selling on the bid. And the market maker is doing the inverse since they're taking the other side. So they are selling on the ask and they're buying at the bid. And so they make the spread.

Jessie:  And the spread is that like seven cents difference?

Jess: Exactly. We're looking at Apple, which is seven cents apart, and the market's closed. If the market was open, it would [normally] be a penny. It's a very, very tight spread is what we would call that. If it's something that doesn't have a lot of volume, because Apple's the most traded security, one of them, of the overall market. If we pulled up something that doesn't trade very often.

Jessie: So we're trying to find something that doesn't trade as often because it has a shorter spread?

Jess: Have a wider spread. So it's gonna have more in between it. It makes sense if you think about it. Because when you are a market maker, you're taking on the other side of the trade. And you actually keep what's called a Delta Neutral Portfolio, which is something that we would have an entire episode on to talk about.

Jessie: What does that mean?

Jess: It means that no matter which way the market moves, it doesn't really affect you, because they make money based on the amount of orders that they receive. So they want more orders. They don't care which way the market goes. And that's how you want them to be, right? Like you don't want them to have a bias for market direction. You just want them to take the spread. Jessie: Oh OK, so a market maker, a market not make her.

Jess: This is fun. I can't say that word without saying her in it now.

Jessie: OK, so obviously a market maker is making money. It's like they're taking those kind of like pennies off the top of the… Is it just stocks, stocks ETFs, any kind of trade?

Jess: Yeah. So, but it's not pennies off the top. They take the spread.

Jessie: Okay.

Jess: So they take the difference between the buy and sell price because they are taking the other side of the trade. They are making sure that there is a market. Stocks that trade more, like Apple, have a very tight spread. because there's more volume associated with it and more opportunities to make that spread. And so they want orders.

Jessie: Right. But the market makers have to have a delta neutral portfolio.

Jess: Right, because the way that they're making money is not by owning stock and hoping it appreciates in value. They're making money by making a market.

Jessie: But they're making money by volume of trades, right?

Jess: Primarily. So that's their, they want volumes of trades, but they can't just create volumes of trades. That doesn't happen.

Jessie: Yeah, that's not up to them.

Jess: No. [as in correct]

Jessie: That just happens based on the economy, the market, whatever's going on, supply and demand, like all those things, right?

Jess: All those things. And that, and when we're talking about this, we're not just talking about retail trading, we are talking about every bit of it, everything that goes into the market.

Jessie: Okay. And just again for our listeners, when we say retail trading, what do we mean specifically?

Jess: We mean everyday individuals, you and I, this is self-directed is retail trading is what that's referred to very often actually. Little fun um finance joke is if we say, like if we're making a compromise, we always call it split the spread.

Jessie: Oh.

Jess: I'll split the spread with you.

Jessie: But we can't actually split the spread. Like who's able to actually split the spread? Anybody?

Jess: Love this question. Uh, that is called price improvement. When you get a better price than the spread, you will have what's called price improvement.

Jessie: How would you get a better price? That really depends on execution quality. And there is a lot to talk about and unpack there, which we can definitely talk about. That's where we have to talk about payment for order flow. So before we move on, we'd need to move on to talk about price improvement. Just make sure that we've got everything covered with what a spread is, the best price to available to buy and sell, all of those things crystal clear. Yes.

Jessie: So the NBBO, aka the National Bid Best Offer, is the best price available to buy and sell the stock at. And the difference of those... two prices, like the bid and the ask, right, is called the spread.

Jess: That's right.

Jessie: Okay. That's usually a few pennies based on how wide the spread is and the wider the spread means that there's less trading.

Jess: Yeah, exactly.

Jessie: It's a little confusing sometimes. There's a lot going on, but that's what we're here for. That's how we're learning all this stuff.

Jess: Yeah.

Jessie: Try to understand how it works and what's going on.

Jess: Exactly. And we're going through the mechanics of the market. Like we, the purpose of the market is you can invest in everything around you basically, like everything. And so we're talking about how that's possible. Now that we know how market maker works, they want orders. And we know that they don't influence the market by creating orders. They can't do that, but things that are traded more often, that's how they're reflected on the bid and ask, right?

Jessie: Yeah.

Jess: Who has orders? Brokerage firms, right?

Jessie: Right.

Jess: There are hundreds of market makers. There are a lot. It's not like there's a handful of them. There are a ton.

Jessie: Oh, okay.

Jess: The market maker will give payment some of that spread that they're making, but it's a prearranged agreement. So it's not like on every trade that happens. They have a prearranged agreement with RobinHood or whatever brokerage firm.

Jessie: So payment for order flow, that's what happens on all brokerage firms then, right?

Jess: everywhere, most brokerage firms. I mean, there are some that do not accept payment for order flow, and there are rules. So when we talked about the national bid best offer, what's reflected on the bid and ask, it's literally the best price available to buy and sell. The second you hit place order and that snapshot of that quote is taken, the bid and ask, if you see that you were executed outside of that bid and ask, you can call your broker and they will adjust it for you. I've done many trade busts in my life and tenure as a broker.

Jessie: Oh, they give you half of the spread or something?

Jess: No, they would give you where you were due. If you think you got a bad fill, which can happen, it's all electronic mostly, and you are like, no, I bought at too high of a price. The ask at that time was lower. Take a snapshot and like, oh, yep, you're right. You were due a fill. Something happened in our system and they will give it to you and give you exactly where that ask was.

Jessie: So when you see what the ask is, should you just get in the habit of taking a snapshot before you hit buy?

Jess: No, I wouldn't. This is all...

Jessie: Like how do you catch it? You know,

Jess: The traders will do this. People who are actively trading are people who care about this.

Jessie: Right. Okay. Yeah.

Jess: But what I think is more important in the grand scheme of things is oftentimes people hear payment for order flow and the complexities of the market and dark pools and see it as such a bad, bad. place that has a bad reputation. And I think taking just a moment to understand how payment for order flow works, the regulation that's there, where you're required to be executed on how dark pools actually work when we get there, price discovery versus price execution and what that all means. We'll hopefully just shed some light on how the system works because we want to utilize the system to our advantage. And. buy stocks so we can participate in capital appreciation and grow our wealth. And the way that you do that is via the stock market. This is the wiring.

Jessie: Yeah, this is just like how it works, right?

Jess: Yeah. Investing is so overwhelming. And so if you see a bid and ask and you pull up a quote and you just want to buy SPY or VOO or VTI or something like that, [you] would immediately get overwhelmed. What is all that information? Now you know, oh, okay, it's just the best price to buy and sell.

Jessie: Where does the dark pool come in?

Jess: Let's go back to that more buyers than sellers, the ask is made up of the lowest sell price because that's where we buy. This is an extreme example. Say you've got a hundred shares that you want to buy and that $100 is the lowest sell price. That means that the next price is going to be a little bit higher. So if there's only buyers, no sellers, the market makers taking the other side, it's going to move the stock higher, go from $100 as they ask then to $101 then to $102 then to $103. So that's how the stock is going up because people are buying it the lowest sell price. So the sell price is getting higher and higher as in what's displayed on the ask. If you have a very big order, like think about how much popularity there is with S&P 500 funds these days. Right. And in order to make those mutual funds, they have share creation where the big institutional investor, which is a mutual fund company like BlackRock Vanguard Fidelity. They have to go in and they have to buy those stocks. That's a huge order if there's enough. We're talking millions of dollars, billions even. If you had to buy millions of dollars worth of Apple, if you'd sent that to the market, you would take all of that stock, the sell orders, and you would skyrocket that stock. And that's if you participated in that's called price discovery. The risk with that is as a retail trader or any type of trader, hedge funds, anyone, anyone is analyzing the market. You'll see this big player come in wanting to buy all of this. You might be like, Oh, somebody knows something I don’t. And you'll buy it too. Like the psychological thing will happen. And then you'll start making the stock go up, which there's literally no reason for it. It's because somebody needs to make a big trade for their big hedge fund or their big mutual fund. Jessie: Oh.

Jess: Yes. So in order to prevent that from happening, the trade is removed from price discovery dark. Like you cannot see how many shares are there. They're still required to be executed at the NBBO and normally it's like an average price. But that's what a dark pool is, is it's designed to not manipulate the market and prevent something called front running, which is where somebody would see that big order. They would go buy them at this other price, as in like a high frequency trade. Think about… price frequency trading means they take advantage of price discrepancies within the market and they trade in like algorithmic milliseconds. So if somebody was looking to do a really big buy order, they could go front run the trade within a millisecond and go buy it from the market and then sell it to them at a higher price. And then that's a form of arbitrage that high frequency trading would do, which is essentially front running a whole position because they see a big order and the whole purpose of putting big trades like that in the dark is to prevent market manipulation. A lot to unpack there.

Jessie: Yeah.

Jess: There's been a lot of regulation since it was first introduced. It's not participated in that price discovery. That's where the issues come about. And it's honestly, it's a debate. If you're not in the price discovery, does that mean is there a better price available to buy or sell? But arguably you shouldn't be in the price discovery as in reflected on the bid and ask because you would artificially inflate or deflate the market. And that would really hurt retail investors. So that would defeat the purpose altogether. But then the big debate is they are very vulnerable to corruption, very vulnerable because orders are put in, I wouldn't wanna say blindly, but it is in a dark area, as in there is less transparency. They're bigger orders, there is requirements for you to be there. And it still has to be [executed] within the NBBO. It's not like you get this special execution that does not happen.

Jessie: So dark pools are intended for institutional investors and super large orders to not move the market and prevent front running. And front running is just a form of market manipulation.

Jess: Right.

Jessie: So they still have to execute within the NBBO, but they don't participate in price discovery. and do report after the trade executes on the tape, quote unquote.

Jess: Yes. So they're like, maintaining confidentiality.

Jessie: Yes. Right.

Jess: So whenever you place the trade is actually what happens in most brokerage firms. They all do it a little bit differently, but it's fairly similar. The second you hit place order, it's going to do a safeguard check, meaning do you have enough money to place this order? Are you going to create a trade violation of some sort? It happens all in a blink of an eye. They do that first. And that's where you'd get that error message, it'd be a hard block or a soft block that says, hey, you can't place this trade or you forgot to hit a zero. You're trying to buy this at a price that is much, much higher than the market and we don't think you intended to do that, things like that. They will have safeguards for you. That's your brokerage firm. Then it may go into an internal inventory that's very possible where they have these shares and they'll match you with buyer and sellers and your firm will take care of it. Or it may go to a dark pool where there's a big order that needs filled. Like somebody wants to buy a bunch of shares of Apple and you're putting in a sell order. So you may hit that dark pool, or it'll be routed to a market maker and the market maker may take that order or they may display it. And then it may be routed to an exchange and then the exchange may execute it. So it could go all different places.

Jessie: So it's not always happening the same way every time that there's a buyer trade.

Jess: No.  

Jessie: Oh OK.

Jess: It's an algorithm. But the algorithm has a rule that is regulated that says the best price to buy and sell, that NBBO, the snapshot in time when it reaches its destination, it has to be executed there. That way, no one takes advantage of you. And payment for order flow. and where orders are routed is so regulated. Rule 606 reporting is what it's called. You can go to any firm's website they are required to give you a link. It's normally in like the little footer area or you can just Google it. You can literally see how many orders they routed where, how much payment they've received for order flow, how much price improvement they've passed on to their customers. There's all these metrics that go through execution quality. The SEC and FINRA are putting in all these regulations to make sure that it's transparent. If you wanna know who's doing what, you can see it.

Jessie: Okay. I wouldn't have known that because I wouldn't have known like, okay, how? Like where do you actually go to see the transparency? So you can just go on your brokerage firm to see what's actually happening.

Jess: Exactly. And if a trade is executed, it's required to be on the last price. Call that the tape. It's gotta hit the tape. You do not need to know all of this. And I will tell you, a lot of people who even work in retail do not even know all of this. This is advanced stuff.

Jessie: Oh, okay.

Jess: Very, probably the most advanced things.

Jessie: That makes me feel better, because my brain is trying so hard. I'm just like, hold on. But I think it's good to know these things, especially if there's a lot of debate about whether it is a free and fair market. And on this show, we definitely... try to just like stick to the facts and educate everyone on what things are, the definitions, how they work. And we try to describe them in an analogy that kind of makes sense just so that we all are on the same page with what the stock market is, how it works, we're demystifying it because it does seem complicated, but it doesn't have to be right.

Jess: Dark pools, they don't present pre-trade type of data. So they don't participate in price discovery and it's important that they remain confidential. And that's where the vulnerabilities are, is if that confidentiality is leaked. And that's what is could be scary about dark pools. That's why the SEC and FINRA are taking steps to create as much transparency as possible to prevent confidentiality leaks or things like that. And when that happens, there are fines. You can go on sec.gov and go on finra.org and you can literally see every FINRA notice or proposed rule change. and studies even of market mechanics. It's really interesting if you wanna go down the rabbit hole and maybe we'll link those into the show notes. But that's the big concern, if you will, with dark pools is they have to have confidentiality. The whole purpose of them is to prevent market manipulation and it's kind of ironic that they are very susceptible to market manipulation. This is the big debate and I don't know the answer to it, but what I do know is that the stock market is, it's highly regulated. It's more regulated than healthcare. Which is crazy.

Jessie: Yeah.

Jess: And we should have an episode on RobinHood. I was very, very so involved in that. It's unbelievable. Part of it is what led to me really giving up my licenses. It is a huge component of it because of the high amount of regulation. And sometimes the regulation is the answer because somebody else did something stupid. But then it also has negative repercussions, because then you create all this regulation. And really you just might need financial literacy, but then you prevent that and you create more barriers to that. So it's just a big debate to be honest.

Jessie: Yes, we really swam into the depths of the investing ocean today. And that was a lot. And as we said, our mission is to demystify how the stock market works to make investing feel less complicated, maybe less intimidating to you. But if you have more questions about anything we covered today. please feel free to ask via our website or any of our social channels.

Jess: Yes, we do it all on this podcast. We see every question you submit. Don't be shy if there's something you'd like me to explain better or answer, or even you want Jessie to go into one of her infamous rabbit holes on, even if it's related to the 16 episodes we've released so far, like we've made it this far guys. Thank you.

Jessie: And if you found today's episode helpful. share it with your squad because sirens may lure sailors to their demise, but they do not gatekeep. So it helps us also if you give us a five star rating or leave a comment or review, your feedback fuels our mission to financially empower all.

Jess: Yes, please leave a review. We love honest feedback here. And until our next financial adventure, keep investing, keep learning and keep breaking those barriers.

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