Dispatches from District 48
Several years ago, a new brokerage called Robinhood successfully began penetrating the millennial market for stock trading with a zero brokerage fee model. In recent weeks, Fidelity, TD Ameritrade and Interactive Brokers have all followed suit (I have accounts with the latter two). This sounds cool until one sits back and wonders how these companies expect to make money instead.
We know one way Robinhood does it --
Payment for order flow is a decades-old practice that can be traced to the early years of electronic trading. It was at his regulated securities firm. (He later became infamous for a multibillion-dollar Ponzi scheme he ran on the side.)
Here's how it works: Retail brokers like Robinhood focus on recruiting customers and building the trading interface, but don't actually execute their clients' orders. They outsource that to firms—including Citadel, Two Sigma and Wolverine Securities—that pay for the right to handle those trades. While orders from large, sophisticated investors can burn the market maker who executes the trade, retail trades are considered relatively safe.
These firms earn a tiny bit of money off each transaction, often 1 cent or less per share. Some see payment for order flow as a critical piece of market infrastructure—facilitating the fast and cheap buying and selling of stocks. But critics of high-frequency trading have long argued that the practice actually hurts the little guy, to the advantage of large firms.
Federal rules dictate that brokers must seek the best execution for clients’ trades, but finding the best price possible is not necessarily a requirement. Consumer advocates say the system creates an incentive for brokers to route orders to the market maker that pays the most.
During last year’s fourth quarter, regulatory disclosures indicated that Robinhood shipped virtually all of its orders for stock trades to four high-speed market makers. The bulk was bought by Citadel, which paid Robinhood an average of “less than $0.0024 per share" on the trades it was routed in that quarter. Those small numbers add up—Robinhood’s users have executed more than $150 billion in transactions.
While companies like TD Ameritrade also accept money for order flow, these payments are far less than the ones helping to keep Robinhood afloat, though that may change now.
I am sure if I bothered to Google search, I could find articles and studies that go both ways as to whether this directed order flow costs a retail investor (in the form of a slightly worse transaction price) more or less than a $5 or $12 commission. Here is my default on this, and it goes back to the saying that if you don't see the sucker at the poker table, then you are it. If something is opaque in the financial world, it is not very likely it is breaking in favor of the retail investor. As such, I would MUCH rather a cost a I see that is well defined than one I do not.