Reg NMS

There is renewed discussion of the possibility of banning payment for order flow in the United States, and the proposed ban appears to be addressing some issues in the wrong way.  Those issues are oddities of "Reg NMS" --- that's "National Market System" --- that convert a dozen or so stock exchanges into a single, abstract "stock market".  And my proposal, ultimately, is that we ban exchanges from charging commissions to liquidity takers.

I want to note that this is ultimately an accounting requirement --- and Reg NMS is why it matters.  If I place an order to an exchange to buy a stock for $64.03, and the lowest price at which anyone is willing to sell is $64.05, the order sits there until someone comes along to sell at $64.03.  If and when they do, the exchange typically charges each of us a commission; I'm really paying $64.031, and they're clearing $64.028.  If the seller were not allowed to pay a commission, you could report the price as $64.031 instead, and charge me a .3 cent commission instead of .2 cents; the same cash changes hands in the same ways, we're just reporting the trade differently.

The problem is that, for many orders subject to certain concessions to the laws of physics (namely the speed at which information can be transmitted), an order to trade "at market" has to go to the exchange with the "best" price.  Because of this, some exchanges actually have a negative commission for liquidity providers --- they might charge me $64.029, and only pay the seller $64.026.  By telling a seller (or, more to the point, the seller's broker) who will only clear $64.026 by selling on my exchange that they can sell there for "$64.03", they can attract a sell order that could perhaps have cleared more (net of commissions) somewhere else.  By requiring that the commission be paid by the trader whose order is resting on the book, you're simply aligning the reported bids and asks with the prices that would actually be obtained by a trader hitting them.

Most of "payment for order flow" similarly constitutes a sleight-of-hand involving careful but economically meaningless distinctions between "prices" and "commissions".