Market structure The Robinhood saga has exposed some significant changes in the way stocks are traded in the U.S.
The commission-free stock trading that Robinhood introduced four years ago, which was followed by Schwab, and Ameritrade in 2019, have changed the revenue
model for brokerage and exchanges. Rather than relying on retail customers to pay commissions, the commission-free brokerages earn money from market makers through payment for order flow (PFOF), interest earned from savings accounts, margin accounts, options trading and various advisory services. Fidelity offers free trades but a spokesman said: “Fidelity does not accept payment for order flow from market makers. The scale of our broad businesses allows us to offer free trading without any trade-offs to the customer. In fact, our retail brokerage customers saved more than $1.6 billion in price improvements on their stock & ETF trades in 2020.”
In a research note on market structure, Paul Rowady, CEO of the capital markets think tank Alphacution, wrote that Rosenblatt Securities noted that off-exchange trading in dark venues “achieved majority or near-majority share of total U.S. stock trading around year-end 2020… At year-end 2020, and for the first time ever, more shares traded on “dark” trading venues than on traditionally ‘lit’ trading venues, like the New York Stock Exchange (NYSE) on a single day.
Alphacution believes that “this is largely – if not, totally – beyond the knowledge and understanding of the public. (These mechanics are also likely outside the knowledge and understanding of many institutional investors.)”
In January off-exchange trading accounted for 47.19% of total equities trading volume, a record.
Rosenblatt Securities noted two shifts to off-exchange venues, said Justin Schack, partner at the firm. One came at the end of 2019, when zero-commission trading was adopted by leading retail brokers. A second, bigger move came as volumes increased — people who were trapped at home started trading more, in part because it was free. They also were getting stimulus checks and some sports bettors turned to the equity markets.
Brokers pay some hefty sums for retail orders —Robinhood received $196.5 million from Citadel in the 4th quarter of 2020 while Schwab got $44.5 million, according to The Economist, which said that payment for order flow is not permitted in Canada or Britain.
Big beneficiaries are limited to a handful of wholesalers who are in both cash equities and options, less than 10 firms, said Rowady. The Economist said that brokers like retail flow because it is manageable and predictable, while institutions can sometimes swamp a broker with large orders or partially hidden orders.
Some retail brokers prefer bilateral relationships with market makers rather than sending orders to exchanges, said Schack. “Firms that lack sophisticated order routing systems and market structure knowledge may want to work with a group of market makers they can trust, knowing that regulation requires prices to be within a best bid-offer range. A lot of firms also like the customer service they get from market makers.
Rowady said brokers like retail orders because they give an early indication of market direction. “PFOF is kind of like a peek at the future. If I can see the flow for Tesla 100 microseconds before the market, I have time to react to that order flow better than the broader market. So I can know when things are going up and down a few microseconds ahead of the trading environment.”
The major bulge bracket firms with asset managers can trade against their internal flows both to reduce the cost of the trade and to trade before the residual flows get into the lit market, he added.
“The proprietary trading firms have set up their own dark pools, whether they're open or closed to others,” added Rowady. “They are largely single dealer platforms and they're getting into the institutional execution services business separate from being wholesale broker-dealers for retail flow Big Ramifications For NYSE NASDAQ and CBOE
“The winners are the firms that offer both cash equities and options, and that is composed of fewer than 10 firms. A lot of cash equity trading is done at low profit, no profit, or as a loss leader because the firms make their money on options,” Rowady said. “So there's an advantage to being a market maker in both cash equities and options because you have more spread to play with. If you think about it theoretically, you have the spread of the option, which is a nickel and you have the spread of the stock which is a penny.”
The dark pools have to honor best execution but that doesn’t mean they have to honor all the rules, Rowady said. By internalizing equities trades they can trade within the penny spread, they can get slivers of a penny per share.
“Two mills or five mills, but when you are trading millions of shares a day, it adds up. in March 2020 it amounted to $600 million through price improvement, even if came at a sliver of a penny for each share. It’s only noticeable in the aggregate.”
In a recent report, Rowady said that Citadel Securities and SIG are the only two of these to have found success – if not, dominance – across the broadest spectrum of hyperactive strategies that include all listed product classes, many asset classes, and most regions.
“Dominant players like Citadel Securities are now able to harvest alpha that used to leak further out into the system and represented what you might call accidental alpha. That was captured by relative value strategies in the active management zone, which is where all hedge funds reside. “So if you think of this playing field where you used to get opportunity, that would leak further and further out into that ecosystem, it’s now being captured by the industrialized use of technology closer to the sources of liquidity.”
The established exchanges are losing some liquidity to dark pools; he expects that at least one of the smaller exchanges will go out of business this year.
“The lit market liquidity has become more toxic, he added. “You're ultimately going up against these high-powered platforms. As more and more of institutional flow gets peeled out of the lit market and directed through the dark market, the lit market liquidity becomes more toxic.”
The longer the big players like Citadel and SIG are dominant the more it bleeds the other players our of business. Citadel is as adept as anybody at finding ways to hedge risk through other instruments; they are masters at 4D chess, Rowady added.
“It would be one thing if they were dominant only on the close or on window-dressing Fridays, if it were a subset, but they are dominant every day. It has already bled the sell-side out of the wholesaling business; they can’t do proprietary or principal trading which is what you need to afford to be on the forefront of technology infrastructure and human capital. They can’t attract talent and don’t have the infrastructure, at least in that piece of their business.”
But don’t feel too sorry for them. Last year was a record for off-exchange trading while it also set records for overall volume in equities and options trading. Rowady sees a parallel between market structure and society structure.
“We are in a similar place in society, somewhere between regulators and legislators finding the spine and a path, finding a consensus to provide some additional rule-making.” Rowady added. “Everybody has co-lo (co-location), that’s a competitive necessity. Now it has dawned on people if you are going to continue to be anybody in this zone of competitors you have to be able to capture some flow you can trade against before it gets out into the lit markets. It is kind of a scummy way to think about the markets — getting a bite at the apple before everybody else does —it’s certainly not free market capitalism.”
Rosenblatt’s Schack takes a slightly less judgmental, but similarly concerned, view.
“The core function of markets is to get the price of something right. The more interaction of supply and demand, the more likely you are to get the price right. I think we need to ask if the level of off-exchange trading is starting to cause problems; I don’t know the answer, but we need to look at it.”
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