Does the quality of trade execution matter in the equities market? University of California at Irvine finance professor Christopher Schwarz and four of his colleagues set out to answer that question with a series of experiments last year. Over a period of more than five months, they executed 85,000 trades with discount brokers in 128 different stocks. What they found was that execution quality varied greatly across not just brokerage firms, but even within the same brokerage. The most shocking finding was their estimate that $34 billion a year is lost to execution costs for small retail investors.
Sure, $34 billion is a lot of money, but is it really? The US had a total equity market value of $53.8 trillion as of the end of 2021, according to data compiled by Bloomberg. If the total market value of US companies turned over one time over the course of the year, which is approximately the case, it would mean that 6.4 basis points (0.064%) would be lost in execution costs. To me, that seems reasonable. But what I think the researchers touched on is that there is a cost to execute a stock trade. It is not an explicit cost, but an implicit cost.
When the discount brokerages collectively eliminated commissions on stock trades in 2019, the move was heralded by many as a boon for retail investors. I was not so sure. As most now know, brokerage firms outsource the execution of those orders to electronic market-making firms, which are for-profit entities. In most cases, retail orders are profitable to trade against, and market making firms are willing to pay brokers to receive those orders. That practice, known as payment for order flow, is now under scrutiny by the Securities and Exchange Commission. The brokerage that gained the most from these arrangements is Robinhood Markets Inc., and it also stands to lose the most if those arrangements are prohibited.
In the old days, a customer would place an order with a brokerage, pay a large commission and the order would be routed directly to the New York Stock Exchange, where it would be received by a specialist. The specialist is a for-profit entity as well, except with the duty to maintain an orderly market during times of stress, and the explicit costs of the brokerage commission was added to the implicit cost of trading with the specialist. Investors were really paying two commissions: a transparent one to the brokerage and an invisible one to the specialist. Now that we have done away with explicit commissions, investors are, on balance, better off.
The interesting thing is that nobody had any problems with trading costs when they were explicit. Investors willingly paid billions of dollars a year in commissions and nobody had any issues 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, even if it reduces transactions costs significantly. There is this perception that the market making firms might be “ripping off” investors. But that isn’t really true. The dealer profit on 25 shares of Coca-Cola Co. is next to nothing, and the vast majority of retail trades are unprofitable or minimally profitable anyway. For the most part, the market-making business is quite boring. The vast majority of profits come from market dislocations, like the meme stocks frenzy in 2021 or the early days of the pandemic. Market makers thrive during periods of volatility.
The market-making firms have a bad reputation, which is mostly unearned. They are the main liquidity providers in the absence of exchange trading floors and specialists. If payment for order flow is eliminated, would we go back to the days of big commissions and specialists? Probably not, but the brokerages and specialists would find a way to make the economics work. I don’t know what that would look like, but it would probably not be superior to the system we have now, where investors enjoy transaction costs of just 6 basis points.
I’m not even sure why we have this obsession over trading costs and frictionless trading, because high transactions costs can be a good thing, forcing people to buy and hold. Inevitably, saving people money on commissions may cost them later in returns in one of the great paradoxes of finance. People waste a lot of time arguing about equity market microstructure. The US has the deepest, most liquid capital markets in the world, but we might not if regulators start getting too involved. As long as competition exists, things will get better and trading costs will come down even further.
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