(Bloomberg) — Last year, five US professors opened two brokerage accounts and placed identical orders to test an algorithm. The next day, one was below $150. The second was up $12.
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They found that this was not a one-time anomaly.
In more than five months, academics used their own funds to execute 85,000 trades across 128 different stocks and made an important discovery: they were getting significantly different prices to buy and sell the shares. The brokerage on premise handled the business. Elaborating from the results, he estimates it costs small-scale US investors $34 billion a year, said Christopher Schwarz, a finance professor at the University of California, Irvine, who co-authored the study with four colleagues.
The paper indicates that there are hidden costs in day trading that are magnified with no-fee brokerage accounts. That’s because even though trades are funneled through a handful of wholesale market makers, including Citadel Securities and Virtu Financial Inc., pricing can vary, according to the paper. And those small discrepancies can have a big impact overall.
“Brokers in the same market center are getting very different execution quality,” Schwarz said in an interview. “Based on statistics, market centers have incredible power over brokers.”
The total cost figure is an estimate of what investors would save if their orders were executed by the best performing of the five brokers in the study, rather than the fourth best. It estimates that some $20 billion in execution costs would be saved if trading costs were cut by 0.10%.
In their experiment, the professors pooled their trades with five different brokers, all of which offered zero commission trading. Only a few of them had pay-by-order-flow deals with market makers, an arrangement that allows large business firms to purchase orders from retail intermediaries. Such arrangements have come under scrutiny since the start of the pandemic meme-stock frenzy because the interests of brokers and markers can be aligned, potentially at the expense of investors. But the study found it had little effect.
While there was a “huge variation” in the prices obtained from buying and selling stocks at different brokers, the cost of executing some trades was as much as 10 times higher – as measured by the basis-point spread charged – when a trade was made. with another through an intermediary.
Of the six market makers that handled orders in the experiment, over 60% of orders eventually went to Citadel Securities and Virtu. A spokesperson for Virtu declined to comment.
Joe Meeken, head of execution services at Citadel Securities, said the paper shows that “payments for order flow have no effect on the prices” investors pay. He also said that it shows that investors “get good performance because they get better prices than benchmarks for bid-ask in exchanges”.
Schwarz said the study results show that some brokerage firms have managed to negotiate better terms with major market makers than others, resulting in very different outcomes for clients. The suggestion, he said, should be scrutinized by market makers that dominate an industry that executes roughly US$28 trillion worth of retail stock orders every year.
To be sure, pricing variation to some degree is normal in any market. Differences may arise due to changes in liquidity, volatility and market conditions, as well as orders sent to the Exchange.
The study authors also stated that their analysis was limited to one aspect of brokerage trading – execution price. The brokerage has other properties that clients can prioritize, such as the range of securities available, research and trading instruments.
The contracts negotiated between brokers and market makers are private. But Robinhood Markets Inc.’s December 2020 agreement with the Securities and Exchange Commission sheds some light on the conflicts of interest between brokerages and their clients. According to the SEC’s settlement order, unidentified market makers told Robinhood that they would have to offer a worse price if the broker wanted to receive a larger share of the overall profit from trades made through the firms.
Schwarz said regulators should demand clear disclosures about the costs that investors pay and the agreements between brokers and market makers.
“It should be easier for me and my friends to figure out the costs than to do it with my own money,” he said. “We will not be able to ascertain these costs based on public disclosure, and that needs to change.”
(Update to add comments from Citadel Securities.)
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