over 3 years ago • 8 mins
Larry Tabb, head of market structure research at Bloomberg Intelligence, joined host Kieron Banerji and Finimize analyst Andrew Rummer to discuss what actually happens when you hit buy on some shares in your trading app. And – now that trading commissions are often zero – how on Earth are brokers managing to make any money?
We discovered how the plumbing of financial markets is much more complicated than you might have realised – and that’s creating opportunities for innovative business models like Robinhood’s zero-commission trading.
Larry also told us how most US retail brokerages nowadays make money from this concept of Payment for Order Flow, where gigantic firms known as market makers or wholesalers pay to transact against small investors. But it’s not necessarily as nefarious as it might first sound – and it generally gives small investors a good deal.
And, finally, Larry explained why so many of these new trading apps have a financial interest in encouraging you to trade options – and why you might want to think twice before dabbling in it.
Here’s a transcript of the interview. Hit 🎧 in the app to listen.
Andrew Rummer: So, Larry, thanks for coming on the show. To kick us off, what exactly is payment for order flow?
Larry Tabb: Payment for order flow is actually a pretty simple concept. Basically, the retail brokerages like Robinhood or or Ameritrade or Schwab collect your orders. You want to buy 100 shares of Apple, you put it in the Robinhood or Schwab app – and instead of Schwab paying for that trade to get executed, actually market makers pay Schwab or Ameritrade or Robinhood for that order flow. So they get the honor of executing against that flow. And that's, you know, that's pretty much it.
Andrew: So what exactly happens if I’m in the US and I go into a trading app on my phone and hit buy on some shares?
Larry: That order, that order does not go to Nasdaq or the New York Stock Exchange. It will go to a wholesaler, someone like a Citadel Securities or a Virtu or G1X – which is another large wholesaler, they're owned by Susquehanna, the big trading firm – or another major wholesaler, Two Sigma. They will execute it generally out of their own portfolio. They'll do what they call internalize that order. Now, regulations at the SEC require these wholesalers to pay at least the best displayed price in the market. If the spread is a penny, they have to execute that stock within that penny. Best spread, if not better.
Kieron Banerji (host): Now here Larry is introducing two concepts that might need a bit more explanation. Firstly, he mentions the spread – which is simply the difference between the price at which you can buy a stock and the price at which you can sell it. There will always be a small gap there. And, secondly, Larry talks about internalization. This is the way that these large market wholesalers – also known as market makers – internally match orders to buy a certain stock with orders to sell – and they’ll match those buyers and sellers with each other within their own systems, without any stocks going anywhere near a stock exchange. Anyway, let’s get back to Larry...
Larry: Now, anywhere between 50% and 80% of the orders that are sent to these wholesalers actually get what they call price improvement, which means that the orders are executed better than that penny spread or better than the best displayed spread in the marketplace. And that's basically because that, you know, at its heart, markets are based on supply and demand. And if you are not buying a lot of stock, it shouldn't move the price. The problem is that the exchanges have what they call fair access. They have to basically do business with anyone who wants to come to them. And so, you know, if you are a market maker quoting in the marketplace and you've got to you've got to quote a price that you're comfortable with executing against yours or my share order of Apple or the smartest hedge funds or this or the largest mutual funds in the world, trying to buy a million shares of Apple. And clearly while my 100 share order of Apple may move the stock a tiny bit clearly, a million share order for Apple would have a much greater impact on the marketplace than my hundred shares. And so the quotes that are represented on the market are actually based more for the smartest folks in the world, with the largest orders in the world, more than your 100-share or my 100-share order. And so, in effect, the prices displayed in the marketplace are wider than they really should be. So if the market maker knows that your order flow is coming from a broker that represents retail order flow, it can generally give that broker a better price or give that order a better price than it can get at the stock exchange. And the profit that they make on trading that 100-share order gets split up in three ways. First, they improve the price of my trade. So instead of trading at a penny spread, maybe it's traded a tenth of a cent or a twentieth of a cent better than the best bid or best offer. The second portion of that is a little bit of money goes back to the broker to compensate the broker, especially now that they don't collect any commissions. So now, really, since October, November of last year, most of the major retail brokers don't charge any commissions. And then the third aspect of that is the wholesaler profitability. So what the market maker or the wholesaler makes in trading, that order gets split into the price improvement that goes to you, payment for order flow that goes to the retail broker and whatever the residual is made by that wholesaler for trading that 100-share order.
Andrew: So do different brokers out there take a larger cut of that per-trade profit and do others pass more of it on to their customers?
Larry: Yeah, absolutely, the different brokers take different amounts. So, like Schwab generally takes less, Ameritrade and Robinhood generally take more. Some firms like Interactive Brokers don't take any.
Andrew: Now that most retail brokerages in the US aren’t charging any direct commissions to clients, how else are they making money – beyond this Payment For Order Flow we’ve been talking about?
Larry: So the other ways of making money is through investing your excess cash dollars – which now that interest rates are so low, that becomes difficult. The other issue is lending out securities. And so hedge funds or other folks who want to short securities, they need to actually borrow them. The other thing is increasingly they're pushing options trades and options trades have much more payment for order flow than equity transactions. So there are all sorts of little ways that these brokers make money depending upon the products that you buy and sell.
Andrew: Would you be worried if your own broker received these order-flow payments from market makers?
Larry: Personally, for me, no. If I'm willing to buy at $10 and I get executed at $9.995 or $9.999 I'm paying less than $10 – so that's a good thing. And whether, you know, Schwab or Ameritrade or Robinhood took an even smaller fraction of that, you know, look, it's way better than than the $5 or $9.99 or $35 or $200 they used to charge when I came into the industry back in the 80s, you know, per transaction. So, you know, the fees for buying or selling have just continually gone down and down and down. Now, you know, next they're going to be paying you to trade. But I don't know who's going to, you know, start doing that.
Andrew: As a veteran observer of markets, do you have any words of wisdom for Finimizers listening to this?
Larry: From this old, grizzly person's view, I would be looking at the long term. I think it's so hard to outfox the market, you know. When you're trying to day trade, you're competing against pretty sophisticated, not just sophisticated traders, but you're you're competing against sophisticated machines. So I would be trying to think about the longer term. What does the world look like six months, a year, three years down the road? And kind of placing your bets that way. You know, even though commissions have gone to zero, the longer term strategies are a little bit easier to figure out and a little harder for the machines to figure out. And so I would look that way. I'd also kind of stay away from some of the options stuff unless you really understand what you're doing. Options trading can be very risky. And one of the major aspects of paying for order flow that these firms receive is from options. The options payments are, you know, three to four times larger than the equities payments.
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