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Fresh off a big raise at a lofty valuation, Robinhood finds itself in the crosshairs of financial media who are attacking its offer of “free trading”.[1] So it begs the question: is this a case of sensationalist journalism?

To try to answer this, let’s take a look at how the industry operates.

How Brokers Make Money

It’s no secret that brokerages have operating costs and have to make money somehow. Broadly speaking, most retail stock brokers operate similarly, and significant drivers of revenue include interest income, commissions, and payment for order flow.

As an example, here’s a snapshot of the 2017 annual revenue contributions by type for TD Ameritrade:

Let’s focus this review on commissions and payment for order flow, which are the hot topics discussed when examining the model of “free trading.”

What are commissions and payment for order flow, and how do they relate to a broker’s business model?

A commission is a service charge paid to a broker in return for executing a trade. Commissions can contribute substantially to a broker’s revenues, as shown in the table I’ve prepared below*:

So how is it that Alpaca, Robinhood, WeBull, and others can offer commission free trading?

Just like the brokers in the table above, they might earn interest income and other account fees. But critics of commission-free trading have highlighted an industry practice called payment for order flow or PFOF. In short, PFOF is the practice whereby retail brokerages are compensated by market makers for sending them your orders, instead of sending your orders directly to an exchange.

Critics would have you believe that you are being sent to slaughter; your orders leaked to frontrunning high frequency traders in secretive kickback schemes. Serious accusations that would be seriously problematic, but here are the facts:

Frontrunning is illegal. I realize that laws don’t always stop people and companies from doing bad things, but ask yourself why would a market making firm, which is typically a profitable enterprise[2], risk its business to frontrun your retail order? Regulation NMS ensures that your order must be filled at a price equal to or better than the National Best Bid and Offer, or NBBO, which is the best available displayed price across all exchanges.

Why would a market maker pay your broker for your order?

But if there’s no funny business going on, why would a market maker pay your broker for your order AND often give you a better net price than what you could get on an exchange in a practice known as price improvement?

Not surprisingly, market makers are willing to pay for your order because on average they can profit from it. The reality is that retail order flow is more diverse and less toxic than institutional flow.

As an example, imagine that you send a market order to buy 100 shares of a stock and that this order is routed to a market maker. The wholesaler receiving your order knows that:

The average retail order does not have more shares behind and hence will not impact price significantly. The average retail order is uncorrelated with past and future order flow. The average retail order does not have a short-term positive expectation. (I understand that this sounds intimidating, but this is the case most of the time. Even most professionals do not have a short-term positive expectation to their trades.) A top-tier infrastructure, a large balance sheet, and a strong predictive model are table stakes here. Even then, competition and efficiency have squeezed market makers’ profits, and retail orders can be winning trades on any time horizon. In fact, one of the largest market makers, Virtu, previously publicly stated a win rate of only 51 to 52%.

As another example, imagine that you send a non-marketable limit order to your broker. This is a passive order that adds liquidity to the order book and is only executed when an aggressive counterparty interacts with it. The wholesaler or your broker themselves may route this order to an exchange that will pay them a small rebate (fractions of a cent per share) if it is filled. The arrangement of receiving rebates for passive fills and paying fees for aggressive fills is the predominant access fee schedule for U.S. equity exchanges and is known as the maker-taker model.

Thus, the bottom line is whether you are crossing the spread or waiting patiently to get filled, the wholesale market maker and your broker can generate a tiny profit on your order, which helps offset their costs and provide you with their services.

Why pay a commission?

It’s a good question that I don’t have a particularly good answer for.

Brokers have long charged commissions, but as the industry has become more electronic and competitive, brokers have continued cutting commission rates[3] in a “race to zero.” It’s worth noting that most commission charging brokers are double dipping; from the 2017 annual reports of large online brokers, TD Ameritrade disclosed $320 million in order routing revenue, Schwab reported $114 million in order flow revenue, and E*Trade generated $135 million in order flow revenue. So in addition to commissions, they also receive PFOF from market makers and/or rebates from exchanges.

What’s better?

Contrary to what recent articles[1] suggest, commission-free trading provides you with a clear and concrete benefit, which is “no commissions.”

Should you really be paying $5 or more to execute 5 shares of AAPL? 1 share of GOOG? Think about that, bid/ask spread aside, you are starting in the hole $5, or 0.47%, on a $1064.71 buy of GOOG at the close of trading on 11/15/18. However, things get better as you execute large dollar value trades.

In the previous example, imagine that you buy 100 shares of GOOG instead of 1 share. At a price of $1064.71 per share and a $5 commission, bid/ask spread aside you’d start only 0.005% in the hole on a $106,471 trade. This seems more palatable, but how often do you expect to be making such large trades?

So what’s one way that commission charging brokers can potentially make up ground on commission-free brokers when it comes to trade execution costs? As noted, both types of brokers usually work with wholesale market makers, who pay the brokers for their order flow. Also previously noted, these market makers may provide price improvement on a customer’s marketable orders.

So for marketable orders, customers can ask whether commission charging brokers are able to provide them with more price improvement than commission free brokers.

From my experience, some industry participants have suggested that there is an inverse relationship between price improvement and PFOF. In other words, if customer orders on average receive more price improvement, then that customers’ broker will receive less PFOF.

Does the public have any data on this? Well, brokers are required to disclose certain information about their order routing in what is known as a Rule 606 report. This report discloses the average PFOF received from wholesalers.

Typically, this is reported in fractional cents per share, but Robinhood reports this as fractional cents per dollar traded, leading some critics to perform calculations that would suggest commission-free brokers are receiving larger PFOF than other brokers and thus providing customers with less price improvement. But this is just one of many possibilities. An alternative explanation is that Robinhood’s order flow has different characteristics (in terms of average number of shares traded or average share price) from other brokers which makes them report their PFOF in a different manner. In fact, this is what Robinhood has publicly stated. One thing is clear however. There’s a lot of competition between wholesale market makers, and retail brokers scrutinize their execution statistics. Nevertheless, this leads me to think that we would all be better off with more transparency. What do you think?

Although some brokers like to tout their price improvement stats here, they only provide averages and tell you nothing about the amount of price improvement you will receive for any given order. In other words, if you give your broker a market order to buy 1000 shares of a stock when the bid price is $31.79 and the offer price is $31.80, it is unlikely to know what price the order will be filled at — $31.7975, $31.7982, $31.7999, $31.80, or any other price between $31.79 and $31.80 are possible.

If you send this order to E*Trade, Robinhood, Schwab, or Alpaca on 100 different occasions, you might get different results each time, without a clear winner in terms of price improvement.

There are many factors such as the bid/ask spread, order size, volatility, and the market maker’s inventory and risk models that affect the outcome, and so calculating your all-in cost including an assumption that you can receive the average price improvement and reported savings per trade is difficult and possibly misleading. It’s unclear who will provide you with more price improvement in the long run without more transparency.

But there is no ambiguity to commissions — you are either charged one or you aren’t. I’ll leave it up to you to decide whether you think commissions are still necessary or not as part of the broker’s business model.

How about dropping commissions and payment for order flow altogether and just sending the orders to an exchange?

While some low commission brokers like Interactive Brokers can route your orders to the venue of your choice, routing your orders to wholesale market makers makes them eligible to receive price and size improvements that are unavailable to institutional traders, as well as prevents them from being subject to exchange or venue access fees.

Who are you?

I’m the Head of Trading for AlpacaDB, Inc., and Alpaca Securities LLC (“Alpaca”) is a wholly-owned subsidiary of AlpacaDB, Inc. Like Robinhood, Alpaca is a commission-free brokerage for U.S. stocks. But Alpaca is bringing commission-free trading to a whole new audience — automated traders.

There’s a growing community of software developers, hobbyist coders, and manual traders seeking automation, who could really benefit from a robust, user-friendly commission-free trading API. Whether rebalancing a portfolio throughout the day or trading a large universe of stocks with a limited capital base, automated strategies often trade more frequently in smaller quantities, and such strategies may not be viable if you had to pay a commission on each trade.

We’ve come a long way from the days of fractional spreads, floor brokers, and big commissions. With increasing competition and automation, many would say the cost of trading is being lowered for retail investors and traders.

Has commission free trading added to your user experience?