Free stock trading continues to cost private investors billions, but not because of the controversial PFOF practice.
Rather, the hidden costs come from differences in price improvement among brokerage firms, according to a new study.
That can cause billions in losses annually among all retail investors, the study’s authors said.
Zero-fee trading apps may have brought a new generation of traders to the stock market, but free brokerages have hidden costs that can add up to billions of dollars a year for retail investors, according to a new study.
Contrary to what many market experts have said about the use of payment for order flow — the controversial practice that involves routing customer orders to market makers who pay the brokerage for those trades — the authors of a new study say that the rising costs associated with free brokerages are the result of a different mechanism.
The study, titled “The ‘True Retail Price’ of Stock Trading” published this month by Christopher Schwarz, Brad Barber, Xing Huang, Philippe Jorion and Terrance Odean, argues that market specialists are not paying for order flow . preventing better execution for retail transactions, as PFOF critics have claimed.
Instead, it’s the quality of pricing and “price improvement” between the brokerage firms themselves that varies, meaning investors can expect to see different performance depending on the trading app they use.
The authors opened accounts with five brokerage firms and executed 85,000 trades, setting them to run simultaneously whenever possible. The result was a surprisingly wide range of prices for identical trades compared to the so-called National Best Bid Price, which all brokerages claim they can beat.
“We find surprisingly large execution differences between brokers,” the authors said, noting that when brokerages direct trades to market makers, it also allows the brokerage to offer a small price improvement to its own users — that is, by allowing clients to sell stocks. at a fractionally higher price or buy shares at fractionally lower prices than in the market.
And the extent of the price improvement is one of the main sources of losses for retail investors, depending on which brokerage they work with. The researchers claim that TD Ameritrade comes out on top in terms of price improvement, while Robinhood was less competitive in their study.
These pricing differences could lead to billions in annual losses for retailers, the study claimed.
“We find economically large price execution differences between brokers that, aggregated across all retail trades, would potentially add tens of billions of dollars in unnecessary annual costs to retail traders…While we knew such trades would not be ‘free,’ we were surprised by the range of strike prices for our simultaneous identical trades,” the authors said.
Regulators have long criticized the hidden fees retailers pay for using commission-free brokerages, but their focus has been mostly on PFOF. The Securities and Exchange Commission, for example, slapped Robinhood with a $65 million fine last year for directing customer trades to market makers that didn’t offer the best price, and SEC Chairman Gary Gensler recently proposed new rules for greater transparency among brokers who use PFOF to offer free transactions to customers.
But the study ultimately argues that focusing on paying for order flow may be misguided.
“We find that PFOF does not explain substantially any of the observed performance differences,” the researchers said. They noted that practice accounted for only 3.4% of the differences in price improvement among retail brokers.
“Since the PFOF does not explain our findings, we are turning to market centers to try to disentangle the factors driving the fluctuations in price execution. In the end, we find that the differences in our prices are due to different brokers getting different execution prices for the exact same trade in the same venue.”
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