TL;DR

Provably fair pricing requires that market participants compete on a provably level playing field. Fairly pricing assets in a world of information asymmetry boils down to a discussion of ‘fairness for whom?’, as some parties have access to better signals than others. Market Makers with privileged access to trading signals than less sophisticated industry participants routinely turn a profit in virtue of their better understanding of the markets - in effect, these traders have tomorrow’s newspaper. This practice, the raison d'être of PFOF, distorts market prices and creates inefficiency. Similarly, failures to publicly disclose assets in reserves backing stablecoins, or the sources of unusually high yields for retail users, both distort price significantly on one side of the information asymmetry. The world of peer-to-peer, permissionless exchanges have various similar barriers to fair price discovery; such as slippage, MEV, old fashioned front-running and varying methodologies around decentralized price discovery. 

Payment for Order Flow (PFOF)

Market Makers pay brokerages for trades routed to them for fulfillment. For instance, Citadel acts as a Market Maker for Robinhood. When Robinhood has orders at certain price points from retail participants, these orders are routed to Market Makers like Citadel. Citadel is happy to take these trades because they reliably stand to profit from the bid-ask spread. A portion of this profit, or that from other revenue streams (should they exist) is then paid to Robinhood as PFOF. The fact of Citadel, and similar Market Makers, routinely being able to turn a profit executing trades for retail investors speaks to their sitting on the beneficial side of an information asymmetry. While there is certainly an obvious case to be made that retail traders utilizing such systems often pay low, if any, transaction fees, the fact of the Market Makers’ turning a profit on such trades suggests the user is not getting the best available price. 

A fundamental controversy associated with PFOF and the retail trader environment is that Market Makers get the first look at a great amount of market signals. The benefits of such market dynamics are often cited as low-cost trades for customers, facilitating the innovation of popular retail focused investment and trading tools (such as Robinhood) and efficiency improvements in trade execution. PFOF has been a feature of the markets since the 90’s, although the rise of ‘meme stocks’ has caused fresh scrutiny of the practice. Robinhood agreed to pay the SEC $65 million in late 2020 to settle charges relating to their failure to communicate their business model to customers. An additional grievance from the regulators was Robinhood’s explicit claim that traders were given similar quality prices to those available from their competitors; a claim which the SEC challenges with the observation that Robinhood’s users lost $34.1 trading on the platform once trading ‘fee’ ‘savings’ were taken into account. More on Robinhood’s revenue stream via PFOF can be found in their Rule 606 and Rule 607 disclosures. 

The largest and most prolific Market Makers in the world of TradFi will describe publicly how Execution Quality is a configurable parameter, a dial to be turned, depending on the profitability of specific brokers. The CEO of Virtu Financial, a financial services firm with ~$10 billion AUM and a leading market maker, explains on this call how the business of professional market making only really works sustainably for the market maker in cases where a great many brokerages are being serviced. Meaning, the market maker is only going to reliably make money when they have lots of different sources of order flow which can be profitably matched or arbed against one another. So the price one gets at Robinhood for a stock purchase is to be compared against other brokerages, with any difference in price best explained as a function of information availability from the perspectives of the market maker and the brokerage.    

SEC chairman Gary Gensler said, in August of 2021, that outlawing PFOF style practices was not out of the question. Although this has clearly not materialized, the regulatory environment remains open to change as FinTech marches on. Robinhood has seen revenue in the hundreds of millions of dollars generated by PFOF on crypto trades.

Fairly Pricing One’s Digital Money

Interest rates on digital assets can be thought of as a way of measuring the value of money. In order to get a fair assessment of the value of money one can either look at the price people are willing to pay for it, or do some analysis. Taking the analysis route, how valuable is one’s deposit to a centralized lending house like Celsius? In order to make an assessment of the price being offered here, as represented by the APY interest rate, one needs to be working with an understanding of how these funds are going to be leveraged to generate yield. For instance, in the event of lender rehypothecation of user funds (i.e. when a lender takers a borrower's collateral and uses it to cover their, the lenders, positions), this might be something that is required to be priced into the interest rates if one is aiming for fairness. Similarly, knowing the exact makeup of stablecoin issuers reserves enables market participants to make informed decisions and ensures a market price that’s more fair. The alternative allows for artificial price manipulation by pretending it’s more difficult to add to the reserves and mint the stable asset commensurately. 

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