Opinion: Commission-free stock trading on some platforms can increase costs and volatility for all of us

The growing use of payment for order flow in US equity markets could increase volatility and costs for all investors by moving more money from exchanges to market makers.

Payment for order flow, or PFOF, directs certain commission-free broker orders to off-exchange market makers, including Citadel and Virtu, rather than traditional exchanges. Last year, the 12 largest U.S. brokerage firms earned a total of $3.8 billion from PFOF, up 33% from 2020, according to information compiled by Bloomberg Intelligence released on Feb. 1.

This marked change should not be underestimated. Gary Gensler, Chairman of the Securities and Exchange Commission (SEC), said in a speech in June 2021 that “[i]In January, almost half of trading interests in the equity market are either in dark pools or internalized by wholesalers.

Instant benefits

Orders from commission-free brokers have relatively slow transmission times, which makes them attractive to off-exchange market makers. The longer it takes for orders to reach market makers, the greater the likelihood that prices will move. As a result, market makers have a greater opportunity to make an instant profit.

Thanks to PFOF, the popular Robinhood HOOD trading app,
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routes about 40% of its trades through just three venues, all of which are off-exchange market makers. The Citadel alone executes 25% of the daily volume of options on stocks listed in the United States and 28% of retail equity trading in the United States.

Because of the PFOF, an investor who places a limit order on a trending stock or option may find themselves chasing the market or paying more. Limit orders can only be executed at or above a specified price. Orders, such as bid/ask spreads from market makers, provide liquidity to other investors looking to buy or sell at the best available price, known as “market orders”.

Off-exchange market makers use high-speed trading technology to execute orders in real time. When the market moves before a limit order arrives at an off-exchange market maker, the market maker is able to execute that profitable limit order and send orders that have strayed from the market to a stock exchange. Market makers are allowed to put these winning positions on their own books in a process called “internalization”.

In the example above, the off-exchange market maker will internalize the client’s limit offer with instant profit and send the limit offer to an exchange where the investor will have to wait for the market to go up before executing or replacing the order by a lower limit price.

Order imbalances

Combined with trading algorithms, this practice can lead to more artificial order imbalances and higher volatility for investors. For example, in the event of a stock falling due to adverse news, off-exchange market makers may repeatedly internalize profitable trades in a stock while transmitting unprofitable orders to exchanges. This can cause unexecuted sell orders to form behind falling stock, while limit buy orders, having been internalized, are unavailable to investors looking to exit. This artificially lowers the price.

Commission-free brokers know that slow order transmission can affect their clients, but with PFOF they have no incentive to prioritize speed. With almost all of their income coming from the PFOF, they may well have an incentive to provide slow transmission times.

For example, there are a few indicators that Robinhood has ignored its relatively slow transition times. Despite founders who previously ran a high-frequency trading hedge fund and started a business that sold high-frequency trading software, reports suggest that Robinhood’s apps are noticeably slow, resulting in poor execution for their clients. .

New entrants

The problem may get worse. When market structure allows insiders to profit at the expense of retail investors, it often attracts new entrants. Other alternative trading systems are moving into the US retail market, including a recent announcement from Jump Trading, and Revolut recently announced that it offers commission-free trading using PFOF.

As this problem continues to grow, the United States seems reluctant to ban PFOF even when studies show that individual investors often have higher all-in costs with commission-free brokers than with traditional brokerage accounts.

In contrast, order flow payment is banned in the UK In November 2021, the European Union made a formal proposal to ban it.

Commenting on a potential SEC ban on PFOF, Citadel’s Ken Griffin told the Economics Club of Chicago on Oct. 4, “Payment for order flow is a cost to me. So, if you are going to tell me that by regulatory decree, one of my main expense items disappears, I agree with that.

His statement assumes that these exchanges would be routed to the Citadel without these payments, which seems unlikely.

When it comes to eliminating their information advantage due to slow data transmission, these market makers become openly defensive. When the SEC approved IEX’s “D Limit” order type, which was designed to give investors a way to buy or sell stocks on the exchange while protecting investors from adverse price movements (obsolete orders) due to slower data transmission times, Citadel objected and sued the latter.

The story of companies profiting from retail investors raises additional red flags:

Regulators should request:

  • Does the structure of the U.S. market, including the PFOF, which allows slow-traffic retail orders to be routed (for a fee) to high-speed trading firms, impact costs for all American investors?

  • If so, given the industry’s checkered history of failures in transparency and best execution, should regulators ensure that slow retail order transmission is not intentionally priced in to increase profits of commission-free brokers and over-the-counter market makers?

Regulators such as the SEC, FINRA and state securities administrators should use their powers to access data from exchanges, commission-free brokers and market makers.

Today’s forensic market experts are well prepared to use this data to analyze and answer these important questions. Whatever the final decisions made by regulators, the results of these investigations would help to restore the necessary confidence of investors in the American markets.

Tom Glynn is the former CEO of DEPFA Bank PLC and a former board member in charge of capital markets and asset management for Hypo Real Estate Bank AG. John Padrnos is the founder of Devon Capital Advisors Ltd. and a former lawyer for Bankers Trust Co. Both are members of the management team of Devon Capital Advisors.

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