Hidden cost of free trading? $34 billion a year, the study says

(Bloomberg) — Last year, five U.S. professors opened two brokerage accounts and placed identical orders to test an algorithm. The next day, one was down $150. The other went up $12.

Most Read by Bloomberg

They discovered it wasn’t a one-time anomaly.

Over five months, the academics used their own funds to execute 85,000 trades in 128 different stocks and made an important discovery: they got significantly different prices to buy and sell stocks, depending on which brokerage firm handled the trade. The results estimate that it costs U.S. retail investors as much as $34 billion a year, said Christopher Schwarz, the economics professor at the University of California, Irvine who co-authored the study with four colleagues.

The document indicates that there are hidden costs for day trading that multiply along with no-fee brokerage accounts. That’s because even though trades are channeled through a handful of wholesale makers, including Citadel Securities and Virtu Financial Inc., pricing can vary, according to the paper. And these small deviations can have a big impact overall.

“Brokers have very different execution quality in the same market,” Schwarz said in an interview. “Based on the data, market centers have incredible power over brokers.”

The total cost amount is an estimate of what investors would save if their orders were executed by the five best performing brokers in the study instead of the fourth best. It estimates that about $20 billion in execution costs would be saved if transaction costs were reduced by 0.10%.

In their experiment, the professors placed their trades simultaneously with five different brokers, who offered zero trading fees. Only a few of them had payment-for-order flow agreements with market makers, an agreement that allows large trading firms to buy orders from retail intermediaries. Such arrangements have come under scrutiny since the beginning of the pandemic’s meme-stock frenzy because the interests of brokers and indicators can be aligned, potentially to the detriment of investors. But the study found it had little impact.

There was, however, a “very wide variation” in the prices achieved by buying and selling shares at different brokers, with some trades costing 10 times more to execute — as measured by the spread on the basis charged — when made through one intermediary rather than another.

Of the six market makers that handled orders in the experiment, more than 60% of all orders ultimately went to Citadel Securities and Virtu. A Virtu spokesman declined to comment.

Joe Mecane, head of execution services at Citadel Securities, said the paper shows that “paying for order flow has no impact on the prices” investors pay. He also said it shows investors are “performing well because they are better priced” than the benchmark for stock market bid-ask spreads.

Schwarz said the study’s results suggest that some brokerages have been able to negotiate better terms with large traders than others, resulting in vastly different outcomes for clients. He said it suggests there should be greater scrutiny of the traders who dominate an industry that executes about $28 trillion worth of retail U.S. stock orders each year.

Certainly, some degree of price fluctuation is normal in any market. Differences may arise due to changes in liquidity, volatility and market conditions, as well as the type of order sent to the exchange.

The study’s authors also said their analysis was limited to one aspect of brokerage trading — the strike price. There are other features in a brokerage firm that can prioritize clients, such as the range of securities available, research and trading tools.

Contracts negotiated between brokers and market makers are private. However, the settlement of Robinhood Markets Inc. in December 2020 with the Securities and Exchange Commission shed some light on conflicts of interest between brokerage firms and their clients. According to the SEC settlement order, unidentified traders told Robinhood that they would have to provide worse prices if the broker wanted to receive a larger share of the overall profits from the trades it routed through the firms.

Schwarz said regulators should require clearer disclosures about the costs investors pay and how deals between brokers and market makers affect them.

“It should be easier to calculate the cost than for me and my friends to do this with our own money,” he said. “We would never be able to calculate these costs based on public disclosures and that needs to change.”

(Updates to add comments from Citadel Securities.)

Most Read by Bloomberg Businessweek

©2022 Bloomberg LP

Leave a Reply

Your email address will not be published.