Why Free Trading Will Never Be Free

As retail trading booms during the pandemic, much attention has focused on one key way that some zero-commission brokers make money: by sending customer orders to outside trading firms, and collecting payments from those firms in return.

Brokers argue that investors often get an even better price on their trades than what is offered in the market, and the system has been able to reduce other fees such as commissions, which helped more people start investing. Is. But critics argue that sell orders may be sold to the highest bidder to profit the broker, instead of being executed optimally for the client.

The debate has kicked into a high gear of late. Securities and Exchange Commission Chairman Gary Gensler has said the agency is reviewing the practice and sanctions are on the table. On Tuesday, he told a Senate hearing that the so-called PFOF could present “multiple conflicts of interest.”

But while shares of retail brokerages such as Robinhood have been under pressure, they have hardly fallen. In part, this is because paying for order flow is one of several ways that brokers have historically used – or could – make money from trade flows in the future.

For example, many large retail brokers have their own market-making units, and have matched customer trades within their systems, sometimes referred to as internalization of order flow. Many have sold units that compete with firms that make up the wholesale market today, such as Citadel Securities or Virtu Financial. Interactive Brokers was in the options market-making business until 2017, when it began discontinuing the practice.

This is not an easy way to earn money. Running a trading desk is regulatoryly complex, and it can consume a lot of capital. But it was a significant revenue generator. Autonomous Research analyst Christian Bolu noted that E*Trade’s revenue-per-trade was down about 40% after selling its market-making unit. Similarly, based on what Interactive Brokers had historically generated in typical revenue as a market maker, Robinhood could in theory generate more on its volume than it is today, said Wolfe Research analyst Steven Chubak. According to.

Robinhood has said that it may explore internalization in the future, just as the firm made its direct ties to the clearinghouse. But it is not clear whether those past economics can be achieved today. One reason brokers exited the market-making business was because they were competing with increasingly sophisticated high-speed trading outlets. Instead sell orders were a way to maintain a lot of revenue without incurring many costs. Mr Chubbuck estimates that Robinhood may initially be able to turn around 60% of its revenue from pay-as-order flows internally.

Still, along with other revenue moves, that could be enough to keep the free-trade model afloat. In addition, the need to be in a market-making business could deepen the gap around big stores like Schwab, Morgan Stanley’s E*Trade or the emerging Robinhood, and the wave of digital wallets offering trading tools for novice investors. can slow down.

But the concern with PFOF is not limited to the narrow practice of selling flows to a third party wholesaler. Mr Gensler linked his views on payment of order flow to larger issues of market transparency, such as “dark” prices that do not appear on exchanges. In the past, internalization has also been a concern about conflicts and transparency. Mr Gensler also discussed discounts, or payments, in recent comments that exchange brokers can make to send certain orders directly to their markets rather than go through the wholesaler – another alternative to generating revenue from trading. Method.

A perfectly level market playing field is what many small traders want to see. But there are a variety of views on what an ideal market structure is. There may also be potential costs to consider for some investors, such as those who invest primarily through pensions, indexes or mutual funds that trade very large sizes. These managers often favor “dark” spots to help them trade in size without affecting prices.

Many individual traders can now also own brokerage stocks such as Robinhood, or other digital firms that offer trading such as SoFi Technologies or Square. So to think about the market structure you would need to picture yourself wearing many different hats.

There are other non-fee revenue streams available to emerging brokerages, such as cash management, or lending stocks to other market participants. But clients can also have problems with things such as short selling by looking at their holdings. In the end nothing can be truly free, including trade.