Retail Trading
Most online discount brokerages offer $0 commissions on trades nowadays. This was simply not a thing a few years ago. Commissions have been coming down for decades without a dramatic change in investor behaviour. Going from $10 to $0 seems to be having a far greater affect on markets than going from $50 to $10. Exhibit A is the new boom in retail trading that has lead to an increase in Robinhood accounts, WallStreetBets members, and call option volume. It’s also lead to a congressional hearing with someone that goes by the name Roaring Kitty.
Last week members of congress hosted an online hearing with the CEO’s of Robinhood, Citadel, Reddit, and Melvin Capital; four firms in the center of the Gamestop stock bubble. Another person at the hearing was Keith Gill, who goes by Roaring Kitty on Youtube and DeepF******Value on Reddit. Gill’s youtube videos explaining his fundamental analysis on Gamestop became a hit on WallStreetBets, which lead to everyone buying Gamestop in their Robinhood accounts (okay not everyone, but a reported 56% of Robinhooders owned Gamestop at the peak).
At the center of the controversy was Robinhood’s relationship with Citadel, who is the biggest US market maker. The relationship is basically that Citadel pays Robinhood for their order flow, which means that when you buy or sell a security on Robinhood, it gets directed to Citadel for execution. In the height of the bubble, Robinhood limited purchases of Gamestop and other meme stocks, which many believed was due to Citadel who also has a relationship with Melvin Capital, a hedge fund that was short Gamestop. It was actually because of Dodd Frank clearinghouse margin rules, but don’t let pesky facts get in the way of a good conspiracy theory. Still, payment for order flow (PFOF) received a bulk of the questions from congress.
Brokerages are able to offer $0 commissions because they can make money in other ways. One of those ways is cash sweeps, which basically means they make interest off of the idle cash sitting in your brokerage account. Charles Schwab actually makes the bulk of their revenue through sweeping cash. Obviously it’s not as profitable these days with close-to-zero interest rates, but it still makes money. The other way is through PFOF. To understand the economics of PFOF, we have to understand the economic of market making.
Let’s say that AAPL is trading on the NASDAQ at a bid of $100.00 and an ask of $100.10. If a Robinhooder puts in a trade to buy 1 share, it will be routed to Citadel who is a member of the NASDAQ exchange and they can execute it for them at a price of $100.10 on the exchange. Let’s say another Robinhooder goes to sell a share of AAPL. It also gets routed through Citadel who can sell the share for $100. Does it make sense for Citadel to do that though? If there’s buy and sell orders coming through Robinhood, why not just match them without having to go to the exchange?
If Citadel just matches trades internally, they could give Robinhooders a better price and make a profit at the same time. If Citadel buys the AAPL share off the Robinhooder selling for $100.03 and then sells it to the Robinhooder buying the AAPL share for $100.07, both Robinhooders get a better execution price and Citadel makes a 4 cent profit. Now Robinhood knows that there’s lots of money in market making from their retail order flow, so they charge Citadel for this. Citadel could pay 1 cent of their profits and still be profitable. Win win win win.
This is basically how payment for order flow works. But there is a reason why PFOF works for retail trading and not institutional trading. Retail traders are what’s known as “noise traders”. Basically, each individual trader does not have a lot of capital and likely doesn’t have information that the market as a whole has, so when they buy, that’s not necessarily an indication that there’s going to be a lot more buys. It’s different for institutions. Say Fidelity sends a large buy order in for a mid-cap. Market makers know that this could be tip of the iceberg, and so they are much more hesitant to take the other side of the trade with their own capital, as the price could keep moving the wrong way on them without matching them with a seller. Citadel doesn’t really want to take the other side of this trade with their own capital and hope to match it, which ultimately means Fidelity gets a worse execution price.
This is a big misconception about markets. Most people believe that big institutions get better execution prices. While it may have been true that all-in execution prices were worse for retail when they were charged commissions, it’s no longer true now. By virtue of being a small, uninformed trader, market makers like Citadel are happy to execute your trade for less because they know you are not going to move the market and they can match it on their own books.
Also, just because this doesn’t happen on an exchange, doesn’t mean it’s not regulated. Brokers like Robinhood are audited carefully by the SEC to ensure they are providing best execution to clients. Same is true for regulatory bodies in Canada. Trades don’t need to happen on an exchange. This is a good thing! You could argue that retail traders could get an even better price if Citadel didn’t pay for order flow (as they would be able to match trades at an even tighter spread), but then Robinhood might have to charge commissions for trading, making the all-in price for the trade much worse.
I’m obviously not arguing that retail trading is a good thing. I’m arguing that markets aren’t rigged against the little guy, at least in terms of trade execution. Retail traders will get an even better execution price than institutions do if both parties hit market at the same time. That’s because market makers know that retail traders don’t have much money and don’t have much information.
