Free trade is not free, but we are always better off


Does the quality of trade execution matter in the equity market? Last year, Christopher Schwarz, professor of finance at the University of California at Irvine, and four of his colleagues tried to answer this question through a series of experiments. Over a period of more than five months, they executed 85,000 trades with discount brokers on 128 different stocks. What they found was that the quality of execution varied widely not just between brokerages, but even within the same brokerage. The most shocking finding was their estimate that $34 billion a year is lost in execution costs for small retail investors.

Sure, $34 billion is a lot of money, but is it really? The United States had a total market value of $53.8 trillion at the end of 2021, according to data compiled by Bloomberg. If the total market value of US companies changed once during the year, which it roughly does, this would mean that 6.4 basis points (0.064%) would be lost in fulfillment costs. To me, that seems reasonable. But what I think researchers have addressed is that there is a cost to executing a stock trade. It is not an explicit cost, but an implicit cost.

When discount brokerages collectively eliminated commissions on stock trades in 2019, the move was heralded by many as a boon to retail investors. I wasn’t so sure. As most know by now, brokerage firms outsource the execution of these orders to electronic market making firms, which are for-profit entities. In most cases retail orders are profitable and market making firms are willing to pay brokers to receive these orders. This practice, known as payment for order flow, is now being scrutinized by the Securities and Exchange Commission. The brokerage that has profited the most from these deals is Robinhood Markets Inc., and it also stands to lose the most if these deals are banned.

It used to be that a customer placed an order with a brokerage, paid a large commission, and the order was routed directly to the New York Stock Exchange, where it was received by a specialist. The Specialist is also a for-profit entity, except that it has an obligation to maintain an orderly market in times of stress, and the explicit brokerage commission costs have been added to the implicit cost of trading with the Specialist. Investors actually paid two commissions: one transparent to the broker and one invisible to the specialist. Now that we’ve removed explicit commissions, investors are, overall, better off.

What’s interesting is that no one had any issues with transaction fees when they were explicit. The investors voluntarily paid billions of dollars a year in commissions and no one had any problems with the arrangement. But people think there is something unseemly about a shadowy market-making firm taking the other side of investors’ trades and profiting from them, even though it drastically reduces trading costs. There is this perception that market making firms might “scam” investors. But that’s not really true. The dealer’s profit on 25 shares of Coca-Cola Co. is almost nil, and the vast majority of retail businesses are unprofitable or unprofitable anyway. For the most part, the market making business is pretty boring. The vast majority of profits come from market upheavals, like the meme stock frenzy in 2021 or the early days of the pandemic. Market makers thrive during periods of volatility.

Market makers have a bad reputation, which is mostly undeserved. They are the main providers of liquidity in the absence of trading rooms and specialists. If order flow payments were removed, would we be back to the days of big commissions and specialists? Probably not, but brokerages and specialists would find a way to make the economy work. I don’t know what that would look like, but it probably wouldn’t be superior to the system we have now, where investors enjoy transaction costs of just 6 basis points.

I don’t even know why we have this obsession with transaction costs and frictionless trading, because high transaction costs can be a good thing, forcing people to buy and hold. Inevitably, saving people money on commissions can cost them later in returns in one of the great paradoxes of finance. People waste a lot of time discussing the microstructure of the stock market. The United States has the deepest and most liquid capital markets in the world, but we might not do that if regulators start getting too involved. As long as competition exists, things will be better and transaction costs will decrease even more. More other writers at Bloomberg Opinion:

• Abandoning value now requires dubious assumptions: Aaron Brown

• Matt Levine’s Money Stuff: The Meme-Stock Vacation Is Over

• The stock market’s summer adventure was not real: Jonathan Levin

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jared Dillian is the editor and publisher of Daily Dirtnap. Investment strategist at Mauldin Economics, he is the author of “All the Evil of This World”. He may have an interest in the areas he writes about.

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