Traders on the floor of the New York Stock Exchange
Source: The New York Stock Exchange
With attention focused on Robinhood and retail traders at Thursday’s Congressional hearings, trading volumes are very much in focus, as is the practice of “payment for order flow.”
Talk about a comeback story.
A year ago, retail traders were a declining part of the trading world. Then Covid hit.
Millions stayed at home and got stimulus checks. They went online. With sports largely shuttered, many started looking at retail stock trading for the first time.
In December, 2019, retail trades averaged 13.0% of total trading share volume, according to data from Piper Sandler. By the end of December, 2020, that figured had almost doubled, to 22.8%.
And those retail traders engaged in more than their fair share of trading.
“Not only did the retail share of trading go up, but they drove volumes much higher,” Rich Repetto, who tracks trading at Piper Sandler, told me. Overall trading in 2020 was up 55% compared to 2019, Repetto noted, much of it driven by retail traders.
And the trend is continuing into 2021. Average daily share volumes year to date are 42% higher than 2020, though Repetto noted that first quarter volumes are usually higher than the rest of the year.
How payment for order flow works
That increase in retail trading has come with increased scrutiny for a practice known as “payment for order flow” whereby some brokers receive payments from market makers (dealers) for routing trades to them.
The majority of retail trading is not done on exchanges, it is done by market makers that “internalize” the trades.
Here’s how it works. Let’s say you want to buy 100 shares of Tesla. When you push the button on a trade, you have given your broker an order to buy 100 shares of Tesla at the market price.
Your broker will usually have a pre-arranged agreement with market makers (dealers) who will compete for the order flow. The bigger market makers include Virtu, Citadel Securities, Susquehanna, Jane Street, Two Sigma, and UBS.
Doug Cifu, CEO of Virtu, one of the largest market makers, said that his firm competes fiercely for that order flow: “Most of the brokers have a ‘routing wheel’ and within that wheel, they will send client orders to the market makers based on the amount of price improvement they have provided,” he told me.
The rate of payment for order flow varies from broker to broker, Cifu noted, but is usually fixed within the broker. A broker may charge 10 cents per 100 shares, for example. Others may charge more, some nothing.
The key point, Cifu says, is that Virtu and the other firms must meet best execution obligations, which will usually include price improvement.
Let’s go back to that Tesla trade, to buy 100 shares. Suppose the bid (what a buyer was willing to pay) was $792.80, the ask (what a seller was willing to sell for) was $793.20. The midpoint is $793.00. Cifu said it would be typical to offer some kind of price improvement, perhaps $792.90.
“It’s a riskless trade,” Cifu insisted. “As soon as the price hits us, we guarantee the broker they are getting the best price.” Cifu also noted that in the last several decades bid-ask spreads have declined, execution speed has improved, and fees have declined, all as a result of technological innovation.
Is payment for order flow a good deal for the retail trader?
Still, many market observers have been critical of payment for order flow, among them Better Markets, a non-profit organization that seeks to promote public interest in the financial markets.
In a paper distributed prior to the hearings, Better Markets claimed payment for order flow “is widespread and causes an inevitable conflict-of-interest between the retail broker-dealer’s duties to seek best execution for its customers and its duties to shareholders and others to maximize revenues…These execution costs can outweigh the benefits to retail investors associated with so-called ‘commission-free trading.'”
Cifu says there is no data to support those assertions.
“At a minimum, you are getting the same price you would get if you went to an exchange,” he told me. “Every single broker is routing based on price improvement and a best execution obligation.”
A recent study done by Larry Tabb and Jackson Gutenplan at Bloomberg Intelligence casts doubt on the idea that retail investors are being disadvantaged by payment for order flow: “Retail brokers’ controversial practice of selling client orders to market makers (payment for order flow) benefits equity investors by enhancing execution quality, with our analysis showing that Citadel Securities and its peers returned $3.7 billion in 2020 to investors in the form of price improvement,” the study concluded. “That’s nearly 3x what they paid for that equity flow.”
Still, the idea that if market makers are making money, they must be taking it from retail investors persists.
UBS’ Art Cashin, the dean of floor traders at the NYSE, also is a skeptic on payment for order flow: “If you’re paying for my order flow, is it to get me the best price? What is the advantage? Is it because the dealer is going to trade against it? It’s the public meets a dealer, it’s not like the public meets the public with an exchange.”
However, Cashin offers a simple formula for determining if the transaction is worth it: “Is the payment you are making for order flow enough to offset the free commission, and give you price improvement? If you believe that is true, you should be comfortable with doing it commission free.”
Cifu agrees with Cashin’s sentiment and again insisted that his firm competes fiercely to provide best execution. “This is a very competitive business,” he told me.
The exchanges have a different concern: retail trader orders that are routed to relatively “dark” venues like broker-dealers without interacting with public orders from the exchanges.
“Growing retail investor interest is a welcome development,” Michael Blaugrund, COO of the NYSE, told me.
“But all of this trading in private dark venues means liquidity is becoming less accessible for institutional investors and the price discovery process is becoming degraded,” he told me.