How free is your commission-free trading?
Hi Everyone 👋,
If you’re reading this but haven’t subscribed, join our community of +48k smart, fun & edgy investors 👇
*This is sponsored advertising content.
This is how much Citadel Securities paid to brokers for their order flow.
And it still made $6.7 billion in revenues by doing that.
How do Robinhood and Citadel monetize “commission-free” retail orders, and how are we paying for it?
Let's find out 👇
Ever since the GameStop saga, the term "Payment For Order Flow" (PFOF) started to appear more often within the financial media. Despite its benefits, the practice carries a significant flaw, which makes it highly controversial and debatable.
To find out more, let's put ourselves in the shoes of Robinhood and imagine that we start our own discount brokerage business!
"If You're Not Paying For It, You Are The Product"
Our business model is going to be very simple. We'll create an awesome-looking, irresistible app where clients can trade stocks. We'll charge them a fee for every trade, and we'll execute their orders. Oh, wait... actually we cannot charge commission as everyone else does it for free.
So how do we earn money?
Ok, fine. We'll figure something out. Let's focus on the infrastructure instead.
How do we execute client orders? Well, stocks trade on an exchange, so we can just send the orders there.
Unfortunately, it's not going to be cheap. In addition to various fixed costs, like registration and membership fees, exchanges also operate an interesting transaction fee structure. These are known as the maker-taker fees and are designed to reward liquidity providers and penalize liquidity takers.
For example, a Limit Order is classified as adding liquidity, and will incur a rebate from the exchange - say $0.0020 per share.
On the other hand, a Market Order removes liquidity and will incur a fee. Let's assume $0.0030 per share.
The exchange pays slightly less on rebates and claims slightly more on fees, making a spread every time a market order takes out a limit order.
So how do we deal with this? We could certainly route limit orders to the exchange and earn a rebate, but what do we do with market orders? They represent an additional cost for us, which is higher than the rebate amount...
So far, this doesn't look good for our little start-up...
Couldn't we just find someone who would do all this exchange-connectivity hassle for us? Hopefully, at a reasonable price?
A Helping Hand
- "Hello?... Yes, it's me. Who's calling?.. Oh, nice to meet you, Ken, thank you for your call... Which company you said you were with?.. Citadel? Oh, ok... Yes... What? You want to BUY our client orders? As in, you will take all this order execution headache from us, and you'll pay for that?... Oh, how very nice of you! Thank you very much.... Yes, I think that could work..."
What a lovely chap!
Although, what a strange offer? Why would Citadel do that?
Doesn't it seem completely counterintuitive? We outsource all our work to someone else, and instead of paying them, they pay us! Essentially, we get paid for leveraging Citadel's systems and exchange access.
So generous of them! They probably want to support a new business!
Now we've solved two problems at once! Not only we offloaded our client order execution to someone else, but we also found a new revenue stream!
And this revenue stream – called Payment For Order Flow (PFOF) – is at the core of Robinhood’s business model:
In addition to providing us with vital income, it carries a few other benefits.
Most importantly, PFOF can result in better execution prices for clients.
For example, let's assume there is a new meme stock in town, and there are 1,000 clients who want to buy and 1,000 who want to sell this stock.
Currently, the exchange bid/offer is shown as $99-$101, meaning that customers can sell stock at $99 and buy at $101 (+ the exchange fee for taking liquidity).
However, customers' orders could also be offset against each other instead - the process known as 'internalizing'.
And our trusted partner Citadel knows how to do that.
For example, Citadel can fill the buy orders at $100.50 (instead of $101) and execute the sell orders at $99.50 (instead of $99), earning a $1 spread in the process. A fraction of that dollar will be paid back to us in the form of PFOF as a reward for sending Citadel these orders.
So far, it looks very nice and rosy - clients got a better price, Citadel made a bit of profit, and most importantly, we got paid too.
If that wasn’t enough, PFOF results in several other benefits too.
For a start, it allows brokerages to offer "commission-free" trading. The general public has better access to markets and more opportunities to invest, diversify and control their finances. Yes, more opportunities to speculate too, but that's everybody’s individual choice.
So what is the issue then? If everyone wins, why is there so much debate around PFOF?
And why has Robinhood initially not disclosed PFOF as one of its revenue streams?
No Free Lunch
Imagine we partnered up with a couple of other "wholesalers", such as Citadel, and we now have a choice when routing client orders.
And let's say a client has instructed us to purchase 100 shares of Tesla at a market price. How do we decide who's going to execute this order?
Internally, we can see the following market quotes from our partners:
Who should this order go to?
Since the client is buying, we need to look at the Ask column. The best (cheapest) price comes from Wolverine. If we prioritize our fiduciary duty and optimize for best execution, then this is where the order should go...
But... but the offer from Two Sigma doesn't look too bad either, right? Only slightly more expensive, but the PFOF amount is higher.
But then – why stop here? After all, we also have a duty to our shareholders to maximize their value, which means we need to optimize for profit.
Alright, fine! Virtu, it's all yours! We'll take our 64 dollars, thank you very much!
And this is the primary concern with PFOF practices - it creates a conflict of interest. Do clients get the best execution, or do brokers optimize order routing for their own interests?
If we look at Robinhood order routing report for July 2021 (required under SEC), we can see a relatively even split between the wholesalers:
There must be a specific algorithm that decides how Robinhood splits these orders between the venues.
In its report about Robinhood practices, SEC writes:
"By March 2019, Robinhood had conducted a more extensive internal analysis, which showed that its execution quality and price improvement metrics were substantially worse than other retail broker-dealers in many respects..."
It's not clear whether Robinhood purposefully optimized for PFOF rebates instead of execution quality, but one thing is sure - Robinhood paid $65 million to settle the SEC investigation.
We can find another certainty about order routing practices by looking at brokers with exchange access, such as Fidelity. Have a look at their Q3 2021 report:
As you can see, almost none of the Market Orders made their way to NYSE or NASDAQ! It seems that only Limit Orders are routed to the exchanges. In fact, exchanges were the preferred destination for limit orders!
Hmmm... I wonder why that is?
Let me give you a hint. Remember earlier we mentioned that exchanges penalize liquidity-taking market orders and pay for liquidity-providing limit orders?
Yeah, exactly! Why route a market order to the exchange and pay for it if Fidelity can send it to Citadel and get paid instead?
And it seems like that's what they do. So, without even getting into the details of broker order routing infrastructure, somewhere in their systems, there should be code such as:
If a market order comes in, it will be prioritized for a rebate regardless of the execution quality on the exchange.
Hence, PFOF acts as the hidden cost that enables "commission-free" trading at the expense of execution quality. It adds up to a significant amount of revenue for retail brokers and to a substantial cost item for executing dealers:
The question is – should we be concerned about that?
The government and SEC certainly are.
Are the retail traders?
DISCLAIMER: The publisher does not guarantee the accuracy or completeness of the information provided in this page. All statements and expressions herein are the sole opinion of the author or paid advertiser.
Grit Capital Corporation is a publisher of financial information, not an investment advisor. We do not provide personalized or individualized investment advice or information that is tailored to the needs of any particular recipient.
THE INFORMATION CONTAINED ON THIS WEBSITE IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE, AND DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN INVESTIGATION AND DECISIONS REGARDING THE PROSPECTS OF ANY COMPANY DISCUSSED HEREIN BASED ON SUCH INVESTORS’ OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN.
No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer or the solicitation of an offer to buy or sell the securities or financial instruments mentioned.
Any projections, market outlooks or estimates herein are forward looking statements and are inherently unreliable. They are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur. Other events that were not taken into account may occur and may significantly affect the returns or performance of the securities discussed herein. The information provided herein is based on matters as they exist as of the date of preparation and not as of any future date, and the publisher undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional material.
The publisher, its affiliates, and clients of the a publisher or its affiliates may currently have long or short positions in the securities of the companies mentioned herein, or may have such a position in the future (and therefore may profit from fluctuations in the trading price of the securities). To the extent such persons do have such positions, there is no guarantee that such persons will maintain such positions.
Neither the publisher nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein.