(Bloomberg) — Last year, five American professors opened two brokerage accounts and placed identical requests to test an algorithm. The next day, one was down $150. The other was down by $12.
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They found that it was not a single anomaly.
Over the course of more than five months, the academics used their own funds to execute 85,000 trades in 128 different stocks and made what they see as an important discovery: they were getting significantly different prices to buy and sell stocks depending on which brokerage handled the stock. business. Extrapolating the results, they estimate it costs small US investors up to $34 billion a year, said Christopher Schwarz, a finance professor at the University of California, Irvine, who wrote the study with four colleagues.
The document indicates that there are hidden costs in day trading that proliferate along with fee-free brokerage accounts. That’s because while business is channeled through a handful of wholesale market makers, including Citadel Securities and Virtu Financial Inc., prices can fluctuate, according to the paper. And those small discrepancies can have a big impact overall.
“Brokers are getting a very different quality of execution in the same market center,” Schwarz said in an interview. “Based on the data, market centers have incredible power over brokers.”
The overall cost figure is an estimate of what investors would save if their orders were executed by the best performers of the five brokers in the study, rather than the fourth best. He estimates that about $20 billion in execution costs would be saved if trading costs were reduced by 0.10%.
In their experiment, the professors placed their trades simultaneously with five different brokers, all offering zero-commission trading. Only a few of them had payment-by-order-flow arrangements with market makers, an arrangement that allows large trading companies to buy orders from retail intermediaries. Such arrangements have attracted scrutiny since the beginning of the pademic 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 impact.
There was, however, a “very wide variation” in the prices obtained when buying and selling shares on different brokers, with some trades costing 10 times more to execute – measured by the spread in basis points charged – when done through an intermediary. than with another.
Of the six market makers who handled orders in the experiment, more than 60% of all orders went to Citadel Securities and Virtu. A Virtu spokesperson declined to comment.
Joe Mecane, head of execution services at Citadel Securities, said the document shows that “paying for the order flow has no impact on the prices” investors pay. He also said this shows that investors get “good execution because they get better prices” than the benchmark for bid and ask spreads on exchanges.
Schwarz said the results of the study suggest that some brokers were able to negotiate better terms with major market makers than others, resulting in very different results for clients. He said this suggests there should be greater scrutiny from market makers who dominate an industry that executes around $28 trillion in orders for US retail stocks each year.
To be sure, some degree of price variation is normal in any market. Differences may arise due to changes in liquidity, volatility and market conditions, as well as the type of order sent to the exchange.
The study authors also said that their analysis was limited to one aspect of brokerage trading – the execution price. There are other qualities in a brokerage that clients can prioritize, such as the variety of securities available, search and trading tools.
Contracts negotiated between brokers and market makers are private. But the December 2020 deal by Robinhood Markets Inc. with the Securities and Exchange Commission shed some light on conflicts of interest between brokerage firms and their clients. Under the SEC’s settlement order, unnamed market makers told Robinhood they would have to provide worse prices if the brokerage wanted to get a larger share of the overall profits from the trades it routed through the companies.
Schwarz said regulators should demand clearer disclosures about the costs investors pay and how deals between brokerages and market makers affect them.
“It should be easier to figure out the costs than it is for me and my friends to do it with our own money,” he said. “We would never have been able to figure out those costs based on public disclosures, and that needs to change.”
(Updates to add comments from Citadel Securities.)
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