Ep 60: Replay: Order Routing, Market Makers, PFOF and Dark Pools Explained

Jess: A listener slash friend of mine sent me that Jon Stewart episode on the problem with stocks.

Jessie: And he was talking about payment for order flow and dark pools.

Jess: And I realized I don't know what any of those things are or how they work.

Jessie: And I think you told me that part of your job in the past was educating clients on those sort of things.

Jess: Right.

Jessie: You know how we talked about zero commissions back on episode one.

Jess: All of that was possible with technological progressions in like cost cutting to be able to have operating efficiencies really within the market and the way that that works.

Jessie: So we need to talk about what happens to your order, what a Market MakeHer is, what a wholesaler is and how dark pools work.

Jess: Let's talk about that.

Jessie: That'd be fun.

Jess: Greetings, money mermaidens, merthems and mermen.

Jessie: You are listening to Market Make Her, the self-directed investor education podcast breaking down complex stock market topics from her perspective.

Jess: We're your hosts.

Jessie: I'm Jess Inskipp, the resident finance expert with 15 years of industry experience here to explain all of those complex topics.

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

Jessie: Yes.

Jess: And if you didn't notice, it's October special Halloween themed fancy dress.

Jessie: Oh, were we dressing up today? I didn't even think about that.

Jess: How are we going to approach this probably huge topic without going down too many crazy rabbit holes today? Where are we going to start? We need to start with understanding how orders are displayed.

Jessie: NBBO.

Jess: A what? Wait, say that one more time.

Jessie: National bid and best offer.

Jess: Okay.

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

Jess: NBBO.

Jessie: When you have a quote for a stock, we talked about the last price and the last price is? The last price, the last time the stock was traded and that happens a bunch of times throughout the day.

Jess: When you log in, you look at the stock quote, it's the last price that it was just previously traded at.

Jessie: Right? Perfect.

Jess: Boom.

Jessie: Yeah, absolutely.

Jess: You pull up a quote for Apple, pull up a quote for Microsoft, whatever that price that you see, that's the last price.

Jessie: It's past tense.

Jess: It has happened.

Jessie: It's post execution.

Jess: So when we're talking about the national bid and best offer, that's pre execution.

Jessie: So we're talking about price display and the market is an auction place, right? You are buying at the best available price.

Jess: 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.

Jessie: And that's reflected on the bid and ask and actually pull up a stock quote so you can see a bid and ask.

Jess: We're going to pull up a stock quote for Apple, symbol AAPL.

Jessie: Prices are as of the close today, October 10th, 4 p.m.

Jess: Eastern time.

Jessie: The last price is 178.39, is down 60 cents.

Jess: That is just the last time it traded, which is at market close, 4 p.m.

Jessie: Eastern time, right? If you look at the bid and the ask though, hold on to where it says bid time size and ask time size.

Jess: That's right.

Jessie: So bid time size is the amount of shares attached to that order, but it always is multiplied times 100.

Jess: So that means there are 100 shares available at 178.45 to buy.

Jessie: 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.

Jessie: So you buy on the ask.

Jess: That's the lowest that someone is willing to sell you those shares.

Jessie: So 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.

Jess: It could be a lot of different things, but that is the best available price for you to buy across the entire market.

Jessie: That's what the ask is.

Jess: Okay.

Jessie: The bid is just the opposite.

Jess: Those are full of buy orders because you're going to sell there.

Jessie: That is the highest that someone is willing to buy those shares at, because you want to sell at the highest price possible.

Jess: So it's the highest buys.

Jessie: 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.

Jess: 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 $0.07? That would be a Market MakeHer or a wholesaler.

Jess: So market makers and wholesalers are the same thing? They are very similar, yes.

Jessie: And this is what's so important about understanding the functions of a Market MakeHer and even why we chose our name.

Jess: So they are going to make sure that these prices that are displayed, they're going to make a market in it.

Jessie: They are responsible for price equality no matter what.

Jess: So you actually have to stay true to your word.

Jessie: You display a bid or ask, you're staying true to your word and you are making a market.

Jess: That's what that means.

Jessie: Okay.

Jess: Okay.

Jessie: 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.

Jess: What like fair? Yeah.

Jessie: What we just described is called the top quote.

Jess: That's a level one quote.

Jessie: There's a level two, which is kind of the back of it.

Jess: 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.

Jessie: So you would see a bunch of higher cells right behind it.

Jess: So meaning if there were a lot of buys that go into the market all of the sudden, the ask is going to get higher and higher and higher.

Jessie: And that's what pushes the stock market up in price because there's more buyers.

Jess: Because it's demand, right? Exactly.

Jessie: There's more demand.

Jess: Exactly.

Jessie: Okay.

Jess: Exactly.

Jessie: And that's important to know when we talk about dark pools a little bit later on.

Jess: So just keep that little nugget.

Jessie: When we talk about what? Dark pool? Yes.

Jess: Dark pool.

Jessie: Where sirens live? Just kidding.

Jess: We'll hold that thought.

Jessie: But the bid and the ask, the difference of those two, that's called the spread.

Jess: And the Market MakeHer, oh, keeps the spread.

Jessie: It's all in the name.

Jess: It's the spread as in like the width between the two prices, the price for you to buy and sell at.

Jessie: 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.

Jess: And the Market MakeHer is doing the inverse since they're taking the other side.

Jessie: So they are selling on the ask and they're buying at the bid.

Jess: And so they make the spread.

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

Jess: We're looking at Apple, which is seven cents apart and the market's closed.

Jessie: If the market was open, it would be a penny.

Jess: It's a very, very tight spread is what we would call that.

Jessie: 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.

Jess: 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? I have a wider spread.

Jess: So it's going to have more in between it.

Jessie: It makes sense if you think about it, because when you are a Market MakeHer, 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.

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.

Jessie: So they want more orders.

Jess: They don't care which way the market goes.

Jessie: And that's how you want them to be, right? Like, you don't want them to have a bias for market direction.

Jess: You just want them to take the spread.

Jessie: Stay with us.

Jess: We'll be right back.

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Jessie: We'll see you there.

Jess: See you then.

Jessie: Okay.

Jess: So a Market MakeHer, a market, not make her, this is fun.

Jessie: I can't say that word without saying her in it now.

Jess: Same.

Jessie: Okay.

Jess: Okay.

Jessie: So, um, obviously a Market MakeHer is making money.

Jess: Um, it's like they're taking those kind of like pennies off the top of the, the, is it just stocks? Stocks? ETFs? Any kind of trade? Yeah.

Jessie: So, but it's not pennies off the top.

Jess: 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.

Jessie: They are making sure that there is a market.

Jess: 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.

Jessie: And so they, they want orders, right? But the market makers have to have a Delta neutral portfolio, right? Because their way that they're making money is not by owning stock and hoping it appreciates in value.

Jess: They are making money by making a market.

Jessie: But they're making money by make, like by volume of trades, right? Primarily.

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

Jessie: That doesn't happen.

Jess: Yeah.

Jessie: That's not up to them.

Jess: No.

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

Jess: And that, and when we're talking about this, we're not just talking about retail trading.

Jessie: We are talking about every bit of it.

Jess: Everything that goes into the market.

Jessie: Okay.

Jess: And just again, for our listeners, when we say retail trading, what do we mean specifically? We mean everyday individuals, you and I, this is self-directed, is retail trading, is what that's referred to very often, actually.

Jessie: Little fun finance joke is if we say, like if we're making a compromise, we always call it split the spread.

Jess: Oh.

Jessie: We can't actually split the spread with you.

Jess: We can't actually split this, like who's able to actually split the spread? Anybody? Love this question.

Jessie: That is called price improvement.

Jess: Oh.

Jessie: When you get a better price than the spread, you will have what's called price improvement.

Jess: How would you get a better price? That really depends on execution quality.

Jessie: And there is a lot to talk about and unpack there, which we can definitely talk about.

Jess: I bet.

Jessie: That's where we have to talk about payment for order flow.

Jess: So before we move on, because we 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 available to buy and sell, all of those things, crystal clear.

Jessie: Okay.

Jess: Yes.

Jessie: So the NBBO, a.k.a.

Jess: the National Bid Best Offer, is the best price available to buy and sell the stock at.

Jessie: And the difference of those two prices, like the bid and the ask, right, is called the spread.

Jess: Mm-hmm.

Jessie: That's right.

Jess: Okay.

Jessie: That's usually a few pennies based on how wide the spread is.

Jess: And the wider the spread means that there's less trading.

Jessie: Yeah, exactly.

Jess: It's a little confusing sometimes.

Jessie: There's a lot going on.

Jess: But that's what we're here for.

Jessie: That's why we're learning all this stuff.

Jess: Yeah.

Jessie: To understand how it works, what's going on.

Jess: Exactly.

Jessie: And we're going through the mechanics of the market.

Jess: The purpose of the market is you can invest in everything around you, basically, everything.

Jessie: And so we're talking about how that's possible.

Jess: Now that we know how a Market MakeHer works, they want orders.

Jessie: And we know that they don't influence the market by creating orders.

Jess: They can't do that.

Jessie: But things that are traded more often, that's how they're reflected on the bid and ask, right? Yeah.

Jess: Who has orders? Brokerage firms, right? Right.

Jessie: There are hundreds of market makers.

Jess: There are a lot.

Jessie: It's not like there's a handful of them.

Jess: There are a ton.

Jessie: Oh, okay.

Jess: The Market MakeHer will give payment, some of that spread that they're making.

Jessie: But it's a prearranged agreement.

Jess: So it's not like on every trade that happens.

Jessie: They have a prearranged agreement with Robinhood or whatever brokerage firm.

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

Jessie: Everywhere.

Jess: Most brokerage firms.

Jessie: I mean, there are some that do not accept payment for order flow.

Jess: And there are rules.

Jessie: 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.

Jess: The second you hit place order and that snapshot of that quote is taken, the bid and ask.

Jessie: 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.

Jess: I've done many trade busts in my life and tenure as a broker.

Jessie: Oh.

Jess: Yes.

Jessie: They give you half of the spread or something? No, they would give you where you were due.

Jess: If you think you got a bad fill, which can happen because it's all electronic mostly, and you're like, no, I bought at too high of a price, the ask at that time was lower.

Jessie: Take a snapshot and like, oh, yep, you're right.

Jess: You were due a fill.

Jessie: That's what will happen in our system and they will give it to you and give you exactly where that ask was.

Jess: So when you see what the ask is, do you just get in the habit of taking a snapshot before you hit buy? No, I wouldn't.

Jessie: This is off.

Jess: Like, how do you catch it? You know? The traders will do this.

Jessie: People who are actively trading are people who care about this.

Jess: Right.

Jessie: Okay.

Jess: Yeah.

Jessie: 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 bulls and see it as such a bad, bad place that has a bad reputation.

Jess: And I think under 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 bulls actually work when we get there.

Jessie: Price discovery versus price execution and what that all means will 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.

Jess: And the way that you do that is by stock market.

Jessie: Right.

Jess: This is the wiring.

Jessie: Yeah.

Jess: This is just like how it works.

Jessie: Right? Yeah.

Jess: Investing is so overwhelming.

Jessie: 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, would immediately get overwhelmed.

Jess: What is all that information? Now you know.

Jessie: Oh, OK.

Jess: It's just the best price to buy and sell.

Jessie: Where does the dark bull come in? Let's go back to that.

Jess: More buyers than sellers.

Jessie: The ask is made up of the lowest sell price because that's where we buy.

Jess: This is an extreme example.

Jessie: Say you've got 100 shares that you want to buy and that $100 is the lowest sell price.

Jess: That means that the next price is going to be a little bit higher.

Jessie: So if there's only buyers, no sellers, the market makers take 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.

Jess: So that's how the stock is going up because people are buying at the lowest sell price.

Jessie: So the sell price is getting higher and higher as in what's displayed on the ask.

Jess: If you have a very big order, like think about how much popularity there is with S&P 500 funds these days.

Jessie: Right.

Jess: 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.

Jessie: That's a huge order if there's enough.

Jess: We're talking millions of dollars, billions even.

Jessie: 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.

Jess: And that's if you participated in, that's called price discovery.

Jessie: The risk with that is as a retail trader or any type of trader, hedge funds, anyone, anyone who's analyzing the market, you'll see this big player come in wanting to buy all of this.

Jess: You might be like, oh, somebody knows something I don't, and you'll buy it too, like a psychological thing will happen.

Jessie: And then you'll start making the stock go up, which there's literally no reason for it.

Jess: It's because somebody needs to make a big trade for their big hedge fund or their big mutual fund.

Jessie: Oh.

Jess: Yes.

Jessie: So in order to prevent that from happening, the trade is removed from price discovery and is in the dark.

Jess: Like you cannot see how many shares are there.

Jessie: They're still required to be executed at the NBBO, and normally it's like an average price.

Jess: 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.

Jessie: They would go buy them at this other price as in like a high frequency trade.

Jess: Think about high frequency trading means they take advantage of price discrepancies within the market and they trade in like algorithmic milliseconds.

Jessie: 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.

Jess: 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.

Jessie: And the whole purpose of putting big trades like that in the dark is to prevent market manipulation.

Jess: A lot to unpack there.

Jessie: Yeah.

Jess: There's been a lot of regulation since it was first introduced.

Jessie: It's not participated in that price discovery.

Jess: That's where the issues come about.

Jessie: And it's honestly, it's a debate.

Jess: 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.

Jessie: And that would really hurt retail investors.

Jess: So that would defeat the purpose altogether.

Jessie: But then the big debate is they are very vulnerable to corruption.

Jess: Very vulnerable because orders are put in.

Jessie: I wouldn't want to say blindly, but it is in a dark area as in there is less transparency.

Jess: They're bigger orders.

Jessie: There is requirements for you to be there and it still has to be within the NBBO.

Jess: It's not like you get this special execution.

Jessie: That does not happen.

Jess: So dark pools are intended for institutional investors and super large orders to not move the market and prevent front running.

Jessie: And front running is just a form of market manipulation.

Jess: 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.

Jessie: Yes.

Jess: So they're like American confidentiality.

Jessie: Yes.

Jess: Right.

Jessie: So whenever you place the trade, this is actually what happens.

Jess: In most brokerage firms, they all do it a little bit differently, but it's fairly similar.

Jessie: 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 the blink of an eye.

Jess: They do that first.

Jessie: And that's where you'd get that error message, be a hard block or a soft block that says, hey, you can't place this trade or you forgot to hit a zero.

Jess: You're trying to buy this at a price that is much, much higher than the market.

Jessie: And we don't think you intended to do that.

Jess: Things like that.

Jessie: They will have safeguards for you.

Jess: That's your brokerage firm.

Jessie: Then it may go into an internal inventory.

Jess: 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.

Jessie: 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.

Jess: So you may hit that dark pool or it'll be routed to a Market MakeHer and the Market MakeHer 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.

Jessie: So it could go all different places.

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

Jessie: It's an algorithm.

Jess: 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.

Jessie: That way no one takes advantage of you.

Jess: And payment for order flow and where orders are routed is so regulated.

Jessie: School 606 reporting is what it's called.

Jess: You can go to any firm's website, they're required to give you a link.

Jessie: It's normally in like the little footer area or you can just Google it.

Jess: 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.

Jessie: There's all these metrics that go through execution quality.

Jess: The SEC and FINRA are putting in all these regulations to make sure that it's transparent.

Jessie: If you want to know who's doing what, you can see it.

Jess: Okay.

Jessie: I wouldn't have known that because I wouldn't have known like, okay, how, like where, 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.

Jessie: And if a trade is executed, it's required to be on the last price.

Jess: Call that the tape.

Jessie: It's got to hit the tape.

Jess: You do not need to know all of this.

Jessie: And I will tell you, a lot of people who even work in retail do not even know all of this.

Jess: This is advanced stuff.

Jessie: Okay.

Jess: Very, probably the most advanced thing.

Jessie: Yeah.

Jess: That makes me feel better because my brain is trying so hard.

Jessie: I'm just like, hold on.

Jess: But I think like, it's good to know these things, especially if there's a lot of debate about whether it is a free and fair market.

Jessie: 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.

Jess: 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.

Jessie: We're demystifying it because it does seem complicated, but it doesn't have to be, right? Dark pools, they don't present free trade type of data.

Jess: So they don't participate in price discovery.

Jessie: And it's important that they remain confidential.

Jess: And that's where the vulnerabilities are, is if that confidentiality is leaked.

Jessie: And that's what is could be scary about dark pools.

Jess: 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.

Jessie: And when that happens, there are fines.

Jess: You can go on sec.gov, you can go on FINRA.org, and you can literally see every FINRA notice or proposed rule change and studies even of market mechanics.

Jessie: It's really interesting if you want to go down the rabbit hole, and maybe we'll link those into the show notes.

Jess: But that's the big concern, if you will, with dark pools is they have to have confidentiality.

Jessie: The whole purpose of them is to prevent market manipulation.

Jess: And it's kind of ironic that they are very susceptible to market manipulation.

Jessie: This is the big debate, and I don't know the answer to it.

Jess: But what I do know is that the stock market is highly regulated.

Jessie: It's more regulated than health care, which is crazy.

Jess: We should have an episode on Robinhood.

Jessie: I was very, very so involved in that.

Jess: It's unbelievable.

Jessie: Part of it is what led to me really giving up my licenses.

Jess: It is a huge component of it because of the high amount of regulation.

Jessie: And sometimes the regulation is the answer because somebody else did something stupid.

Jess: But then it also has a negative repercussions because then you create all this regulation.

Jessie: And really, you just might need financial literacy, but then you prevent that and you create more barriers to that.

Jess: So it's a big debate, to be honest.

Jessie: Yes, we really swam into the depths of the investing ocean today.

Jess: And that was a lot.

Jessie: 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.

Jess: 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.

Jessie: Yes, we do it on this podcast.

Jess: We see every question you submit.

Jessie: 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 wrapped holes on.

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