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August 25, 2022 at 04:01 PM
What You Need to Know
- There is a perception that shadowy market makers might be ripping off investors. But that isn’t really true.
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 U.S. 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 U.S. 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.
Industry Structure
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.
