- Robinhood and other free retail brokers drew attention in January during the GameStop mania.
- But these so-called “discount” or “no commission fee” brokers often do not provide best execution of retail customers’ orders.
- Jonathan Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School and Professor in the Yale School of Management.
- This is an opinion column. The thoughts expressed are those of the author.
- See more stories on Insider’s business page.
The ongoing fiasco that grew out of online broker Robinhood’s decision to limit customers’ ability to buy “meme stocks” like GameStop in January has produced a lot of noise, but also a silver lining.
Robinhood’s move, which angered customers and some online commentators, also brought attention to how retail brokers like E*Trade, Charles Schwab, TD Ameritrade and Robinhood handle orders on behalf of their retail customers.
When a customer attempts to buy or sell a share of a stock or other security brokers have a legal and moral obligation to provide their customers with “best execution,” which means that these companies must give their customers the best price “reasonably available.” But this certainly is not happening in US securities markets today.
Retail customer orders with commission-free broker-dealers like Robinhood — that do not charge customers a fee to execute their trade — are sold to high-speed market makers like Citadel Securities and Virtu Financial in a scheme called “payment for order flow.” In essence, Robinhood and other brokers do not actually match a buyer and a seller to complete a full stock trade.
Instead, Robinhood sells their customers “orders” by the millions to market makers like Citadel, who do the hard work of lining up buyers and sellers in exchange for a fee. These high-speed market makers process massive amounts of trades every day and have taken over the market. By paying billions of dollars in kickbacks to retail brokers, on a typical day Citadel processes 40% of all retail securities orders in the US stock market, making Citadel the most powerful middleman on Wall Street.
Citadel, Virtu, and Robinhood claim to benefit the retail investor by offering better prices than they might get on exchanges. It is true that Citadel sometimes gives retail investors a better price than the National Best Bid and Offer (NBBO), basically what regulators have determined to be the best selling and buying price for each security, displayed by the Securities Information Processor (SIP). But the NBBO SIP is a slow data feed that provides incomplete information on buy and sell orders displayed on exchanges.
The NBBO benchmark Citadel and Virtu use is widely understood to be outdated and incomplete. But brokers selling their order flow and the market makers who buy that flow and execute their trades have a strong incentive to ignore non-displayed orders because poor execution quality for retail investors translates directly into profits for them.
The best execution requirement requires best execution. It is not sufficient to provide a slight improvement on an inferior price. To illustrate how the market works, suppose that the displayed NBBO SIP for a stock is a bid, the highest price a buyer is willing to offer, of $10.00 and an offer, the lowest price at which a seller is willing to sell, of $10.30.
A Robinhood customer sends an order to sell 100 shares to Robinhood, which sells the order to Citadel. Citadel might, at its discretion, give a sort of imaginary “price improvement” over the NBBO SIP and buy the 100 shares from the seller at $10.01, a one penny improvement over the “best” bid of $10.00. This gives the retail seller price improvement of ($0.01 x 100 shares) $1.00 over the best displayed bid on the SIP.
But Robinhood’s customers are entitled to more than a discretionary increment of price improvement over the NBBO. They are entitled to the best price “reasonably available,” which means that they should have access to the vast swathes of the market that are not displayed on the NBBO SIP, but are available Citadel and Virtu through their network of systems that track buy and sell orders that are not displayed on the SIP.
In particular, it often is possible to execute a trade at the midpoint between the NBBO best bid and the best offer. Midpoint pricing would have given the Robinhood seller $10.15 for their shaper share price improvement of $15.00 rather than just $1.00. That extra $14.00 represents the profit that Citadel makes on the trade minus whatever pennies Citadel paid for the order flow.
Of course, if payment for order flow were eliminated, commissions for discount brokers likely would return, but even with commission of $7.00 per trade the retail customer is better off without payment for order flow.
In a nutshell, Citadel is in direct competition with the retail investor for the best prices and has paid retail brokers like Robinhood billions of dollars to help them cover up this conflict. In fact, on March 11, Virtu CEO Douglas Cifu admitted in a TV interview that retail customers of brokers like Fidelity, who don’t pay for order flow get better execution quality than customers on venues like Robinhood.
The biggest question facing Gary Gensler as he takes the helm of the Securities and Exchange Commission is whether Citadel and Virtu have a duty to seek the best price in the market or whether the “duty of best execution” has been truncated to mean that customers are only entitled to the NBBO SIP.
At present, Virtu and Citadel decide what, if any, price improvement to give to customers. Price improvement is arbitrary and discretionary. And it’s a zero sum game. The better the deal the retail gets, the less money that Citadel and Virtu make.