It's Really Hard To Ban Payment For Order Flow
Plus: FTX Ventures, SOFR time, DeFi risk, and more
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News
PFOF Is Alive and Well in Europe: A new post about payment for order flow came out of Optiver this week that merits our attention. Optiver is one of the largest quant firms in the world, growing from a one-man shop on the Euronext trading floor in 1986 to a global leader in electronic options trading. Late last year the firm published a series of posts about payment for order flow as it relates to the US options market, shedding light on the mind-numbing complexity that surrounds the PFOF debate. In its latest post published earlier this week, Optiver takes a new look at PFOF in European markets. While classic PFOF technically doesn’t exist in Europe, it almost certainly exists in spirit by other names. The below graphic gives us more context:
(Source)
What is the spirit of payment for order flow? A market maker provides value to a broker in exchange for the broker sending orders to that market maker, even if a better price may exist somewhere else. Each of the above practices fulfills this spirit despite avoiding the strict “PFOF” moniker. Whether it be sending orders to an exchange where certain liquidity providers are the only available option, favoring specific venues when designing a client-facing front-end, or receiving fee discounts instead of outright payments, each practice achieves the same end result as outright payment for order flow. Optiver argues these practices limit competition & result in higher execution costs for retail & institutional clients who use participating brokers.
While digesting these arguments it’s worth remembering the role Optiver & other market makers play in European market structure. Payment for order flow exists because certain trading firms in the US and abroad have built formidable network effects that allow them to provide liquidity at a lower effective cost than other market makers. Most market makers - like Optiver - can’t spend the up-front capital needed to compete with wholesalers that engage in payment for order flow. Lobbying the public & regulators to ban the tactics that give these wholesalers an advantage would benefit Optiver & smaller liquidity providers at the same time.
Despite the potential bias in their post, I tend to agree with Optiver’s core message. While it may be easy to ban the precise definition of payment for order flow, it’s much harder to prevent any exchange of value & services between market makers & brokers that may hurt competition. Regulators in Europe and the US should take this to heart when making policy - it’s easy to ban action, but hard to ban intent, especially in a space as complex & impactful as equity market structure.
Crypto Exchange FTX Sets Up $2 Billion Venture Fund: The sprawling & ever-expanding empire that is FTX continues to make headlines & redefine how we think about the exchange business. The first well-known way FTX pushed the boundaries of an exchange was its marriage with Alameda Research, one of the largest & most active crypto trading firms in the world. An exchange-market maker combo of this size poses both powerful competitive advantages & opportunities to improve how crypto markets work, and the potential for unfair conflicts of interest that don’t put exchange customers first. Given the largely unregulated nature of crypto outside the US, walking the tightrope between powerful force for good & shady corrupt actor is left to FTX’s leader, Sam Bankman-Fried, who has so far shown a desire to avoid the market structure shadows.
News of a new $2 billion FTX venture capital fund takes this Alameda principle to a completely different level. Some details about the VC fund’s launch:
The $2 billion in capital to start the fund came from FTX directly, meaning no outside money is involved.
Investments can range from $100,000 to hundreds of millions of dollars and will be focused on crypto gaming, insurance & security, developer applications & cross-chain startups.
While the fund’s returns will be important, its goals will be more strategic than classic VC firms given its connection to FTX and its other portfolio companies.
This news marks the first time a multi-billion dollar exchange, market maker & VC fund have all existed under the direction of one management team. Sure, exchanges & market makers have invested in startups for strategic & financial reasons before, but this news is different. The combining of strategic, exchange-level goals with broader financial return goals & the sheer amount of money involved implies a new, more substantial investment plan has been put in place at FTX.
Just like the original marriage of Alameda & FTX, the addition of a large VC fund to the mix poses both incredible synergies for the exchange & potential for serious conflicts of interest. An exchange’s core value-add to the world is liquidity - creating an environment where buyers & sellers can trade & make investments quickly, easily, and without impacting an asset’s price. Liquidity also happens to be the value-add of a market maker and a venture capital firm, in different ways & at different stages in a company’s lifecycle. With all three under one roof, FTX can now fund new innovative crypto startups, bring them to market by listing their coins or even equity on its exchange, and then keep that listing active & tradeable with Alameda’s algorithms. Think of this like vertical integration - removing barriers in the chain of liquidity provision saves money, time & fosters more innovation than if the three entities were kept separate.
On the other hand, spectators are already well aware of the negative effects VC firm-exchange combos can have on the crypto market:
The above article describes the typical, rather disappointing lifecycle of an asset in Coinbase’s VC portfolio - Coinbase invests in a coin, the coin’s price rises as Coinbase prepares to list the asset on its massive, highly liquid exchange, and then prices underperform after listing occurs as VCs unload their gains onto the exchange’s retail users. If Coinbase’s exchange & VC firm were separate entities, the incentive to list & promote particular investments would be nowhere near as apparent. Is this the ultimate vision of FTX’s VC arm? I sure hope not.
I’m tempted to end with a cheesy superhero quote about power & responsibility, but I’ll restrain myself simply hope FTX leverages its central role in crypto market structure for the genuine benefit of end users over itself. The money has, and inevitably will, follow.
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Chart of the Week
This week’s chart is a reminder that a really (in my opinion) beautiful thing is happening underneath the surface of CME’s interest rate markets. LIBOR has ceased pricing new loans as of the end of 2021, giving way for its replacement (SOFR) to begin building momentum in 2022 and beyond. The Eurodollar futures market, tied to LIBOR, is one of CME’s top revenue generating products, making the LIBOR-SOFR transition a high stakes operation for the exchange. Bloomberg published a chart this week that shows us how that transition is going so far.
When a new product reaches adequate market acceptance, volumes & open interest can rapidly spike as the adoption S-curve hits its steepest slope. This is what we may be witnessing with SOFR futures today - activity is ramping up alarmingly quickly, bringing liquidity to SOFR options, SOFR swaps & making SOFR price data more robust & valuable. As existing Eurodollar futures positions expire it seems more banks, institutions & interest rate traders are opting to the SOFR alternative.
I expect this slope to only get steeper as the year continues with SOFR surpassing Eurodollar activity by the end of the year, when LIBOR prices are set to cease updating completely.
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Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. As of the publishing of this newsletter, I am long ICE, CME, TW, NDAQ and VIRT. I am also long Solana.