Free Is a Dangerous Word (Especially during a Pandemic)

January 26, 2021

In the past 18 months, we’ve witnessed some extraordinary changes in how retail stock investors trade, from the broad shift for many brokerage firms toward zero commissions to the jump in trading by individuals in 2020, presumably a result of the pandemic. Describing the increased retail trading early in the pandemic, Joe Mecane, the head of Citadel’s execution services, said it comprised as much as 25% of market activity on peak days early in the pandemic versus just 10% historically.1 At Aperio, we look carefully at potential conflicts of interest in how the investment industry gets its revenue, and these changes over 2020 remind us that free can sometimes prove to be a dangerous word for investors.2 In this article we’ll study how such rapid adoption of free trading and the gamification of trading platforms may affect execution quality.

Numerous behavioral economists3 have commented on how consumers can become disproportionately triggered when they see the word free or a price of $0 for services or products. Schwab’s pivot to free trading under competitive pressure from Robinhood started the free-trading trend across mainline brokers and coincided with a major jump in retail trading activity.

How do brokers and market makers perceive those retail trades? Retail traders and financial advisors hold a unique and counterintuitive execution advantage over large institutional players. Market participants regard retail flow as less informed; simply stated, a party that takes the opposite side of the trade is unlikely to be adversely impacted in the immediate term and is thus willing to execute at a better price. That same market maker might be far more cautious executing against a hedge fund or a high-frequency trading firm that may possess an information, size, or speed advantage. The benign nature of retail trading makes it attractive to market maker firms that act as wholesalers and purchase it from brokers. This payment that brokers receive from market makers, known as payment for order flow (PFOF), is what allows brokers to offer free trading while maintaining profitability. While the numbers tend to be small on a per-trade basis (typically around $0.30 per 100 shares), overall, PFOF is a lucrative business, surpassing $2 billion industrywide in 2020.

The chart below, produced by Alphacution, shows the revenue generated by PFOF for the first three quarters of 2020, broken down by quarter and by type of security. Note the big jump in total revenue from PFOF in the second quarter, generally ascribed to market volatility and newfound time for stay-at-home retail day traders. In addition to the effects of the pandemic, we can also see how little of the total revenue comes from big US stocks in the S&P 500, with options and small-cap stocks generating the vast majority of the PFOF revenue. Furthermore, the more volatility the market experiences, the wider the spreads become, making each trade more profitable from a PFOF standpoint.

PFOF has always been a controversial practice and is illegal in many European markets, the United Kingdom, and Australia. When used in moderation, it has the capacity to deliver a nominal profit to the broker and market maker while offering free trading, hopefully maintaining execution quality for the end client. Hypothetically speaking, market makers can offer a spectrum of execution options. At one extreme, they can execute at the midpoint of a spread (what we consider the best reasonable execution an investor can expect), but presumably, the market maker would need to receive some commission, generally fractions of a cent per share, to incentivize them. Alternatively, for no commission, an investor might pay a slightly wider spread. Finally, if a broker or asset manager elects to receive payment for order flow (what we’d characterize as a legal kickback), the end investor would likely pay an even wider spread. In effect, a broker is able to negotiate how much or how little rebate to take, and these negotiations logically have an inverse impact on execution quality.

At one end of the spectrum, certain brokerage firms optimize for execution quality by forgoing a rebate. Fidelity is a proponent of this approach. At the opposite end of this spectrum, the client pays a larger portion of the spread, and the leftover money is rebated to the brokerage firm, as seen at firms like Robinhood. As one can imagine, such a dial capable of dynamically increasing profitability presents a powerful perverse incentive to brokers, especially at a time of industry consolidation and when many traditional sources of revenue are impaired. It is also notable that some brokers publish detailed price improvement metrics while others make this data unavailable. The chart below shows the volumes and average spread rate for primary trading platforms engaged in PFOF in the third quarter of 2020.  

Overall, we think that the shift toward free trading presents the potential to become a net positive for certain consumers, especially those making many small trades. The benefit appears particularly pronounced for direct indexing and tax-loss harvesting strategies that are characterized by higher volumes of smaller trades. However, not all free-trading platforms are created equal, and the shift from easily understood commission rates toward obfuscated implied trading costs produces an environment ripe for abuse.

Last month, the US Securities and Exchange Commission validated our concerns by fining Robinhood $65 million and stating that “Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.”4 Furthermore, the industry revenue model appears to be tilting toward options given their increasing popularity amongst active traders as well as their attractive PFOF characteristics—wide spreads and opaque markets. This backdrop of perverse incentives coupled with limited visibility warrants continued scrutiny. This concern seems especially prudent given the spate of recent mergers among large broker platforms. The PFOF impact of the Schwab/TD Ameritrade merger will be particularly illuminating given their dominant market share and given their legacy PFOF practices lie at opposite ends of the spectrum. It also bears mentioning that the market maker landscape appears to be increasingly top-heavy with Citadel and Virtu emerging as primary players in equities. Both of these developments have the potential to tilt pricing power away from the investor. 

In terms of potential regulatory changes from Washington with a new administration and Congress, former Senator Carl Levin has urged the Biden administration to ban payment for routing order flow, effectively counteracting such trends. In an editorial in the Financial Times dated January 11, 2021, Levin criticizes the practice as “like paying a hidden, private tax on savings ….”5

As always, wise investors, whether retail or institutional, need to look beneath the hood to see what’s really driving pricing, especially when it’s labeled as putatively free. We’re reminded of the climactic scene near the end of the movie The Wizard of Oz, where Dorothy’s dog, Toto, pulls back the curtain, exposing the posturing fake wizard pulling levers and speaking into a microphone. When he realizes he’s been outed, the wizard brazenly admonishes Dorothy, the Scarecrow, the Tin Man, and the Cowardly Lion, “Pay no attention to that man behind the curtain.” We advise that investors show wariness should brokers and market makers try to discourage scrutiny by implying a securities market version, “Pay no attention to those fees behind the curtain.”


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1 “Citadel Securities Says Retail Is 25% of the Market During Peaks,” Sonali Basak, Bloomberg, July 9, 2020.
2 For an example, we cite the history of the label for certain option collars, where an investor pairs the selling of a call option with the purchase of a put option. Firms used to offer these transactions as “no cost collars,” until compliance departments at some Wall Street firms pointed out that such transactions can mean very high costs for investors (and high profits for brokers), but in the form of spreads rather than direct commissions. Thus, such transactions are now sometimes officially called “cashless collars,” although popularly they’re still known as “costless collars,” even though the hidden costs of implementing such positions can prove quite expensive.
3 See, for example, Dan Ariely’s work on free pricing, including references in his book Predictably Irrational: The Hidden Forces That Shape Our Decisions.
4 “SEC Charges Robinhood Financial with Misleading Customers about Revenue Sources and Failing to Satisfy Duty of Best Execution,” US Securities and Exchange Commission, press release, December 17, 2020.
5 “Time to Stop Trading Conflicts That Cost Investors Billions,” Carl Levin, Financial Times, January 11, 2021.


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