Dumb Money

Yan Qin is a freelance consultant and do-it-yourself stock trader who works out of her apartment in Queens, New York. From the comfort of her living room, she keeps one eye on the business TV network CNBC, the other on a laptop computer, where her E*Trade account shows the best prices down to the penny, flickering moment to moment.

She presses a button and the trade is done in less than a second, costing her only $9.99 -- a mark of the easiest and cheapest era yet for individuals to participate in U.S. capital markets.
Qin, 40, who describes her strategy as "impulsive," said she recently purchased 300 shares of Bank of America. Though she didn't realize it at the time, the amateur trader likely got a tad better deal on the stock than even the most sophisticated Wall Street traders.

How did she manage that? E*Trade, rather than shipping her order directly to the New York Stock Exchange or Nasdaq, routed it to a large firm known as a market maker, which sold Qin the stock at a slightly cheaper price -- probably a 10th of a penny. The market maker also paid E*Trade Financial Corp a small stipend, and in return got a chance to profit from what the industry considers "uninformed" trades -- or dumb money, to use the term of art. This little-known circle of compensation, called "payment for order flow," has provided a steady source of income for a select few firms for decades, but lately has again come under scrutiny.

A growing number of critics say that the arrangement segregates the public from the public marketplace. They also say it fuels anonymous and lightly supervised "dark" trading, and hamstrings the exchanges' ability to set prices that reflect an increasingly large spectrum of buyers and sellers.

Of course, none of this is even remotely illegal. Some with a stake in the industry say the arrangement helpfully insulates amateurs from professionally-set share prices -- and the high-frequency trading firms that establish them. Others say it helps nonprofessional traders avoid what they call the punitive trading fees levied by exchanges.

http://in.reuters.com/article/idINIndia-53642420101217