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The 'Actual Retail Price' of Equity Trades
... 5 Second, our approach allows us to directly conduct within-broker comparison of execution costs. Focusing on dispersion within broker is important since there are large variations of execution costs across brokers (Battalio et al. (2001) and Schwarz et al. (2023)). Third, because brokers may have heterogeneous criteria for making routing choices, having a wide range of brokers allows us to examine how different routing choices affect the competitiveness of the wholesaler market place. ...
... There are no other contractual obligations: brokers can route orders to any market centers, 17 One concern is that PFOF could potentially lead to worse execution for retail traders due to its inherent conflict of interest. However, recent research (e.g., Battalio and Jennings (2023), Ernst et al. (2024), and Schwarz et al. (2023)) has largely shown that PFOF does not significantly impact price execution for equity trades. We should note that PFOF has been common for decades, although to a much lesser extent than nowadays. ...
... 21 A major feature of our setup is the placement of simultaneous identical trades (i.e., trades in the same stock of the same order size at the same time), which allows for a controlled comparison across brokers. Further details about the experiment can be found in Schwarz et al. (2023) and Barber et al. (2023), which utilize an early version of this dataset. ...
Using 150,000 actual trades, we study the U.S. equity retail broker-wholesaler market, focusing on brokers’ order routing and competition among wholesalers. We document substantial and persistent dispersion in execution costs across wholesalers within brokers. Despite this, many brokers hardly change their routing and even consistently send more orders to the more expensive wholesalers, although there is considerable variation among brokers. We also document a case where, after a new wholesaler enters, existing wholesalers significantly reduce their execution costs. Overall, our findings and theoretical framework highlight the heterogeneity across brokers and are inconsistent with perfect competition in this market.
... Greater margins? According to a recent study, higher PFOF is not necessarily associated with a lower quality of execution (see Schwarz et al. (2022)). If it is not more profitability, what is it that the investors of the DCA Strategy have to offer? ...
The Dollar-Cost Averaging (DCA) Strategy is an enigma. Proven sub-optimal from a risk-adjusted performance time and again since the late 1970's, it is nevertheless more popular today than ever. Our empirical analysis makes no exception. The DCA Strategy does almost systematically show a lower level of volatility than the so-called Lump Sum Investing (LSI) Strategy, but there is no free lunch. The price to pay is a significantly lower level of return, leading more often than not to lower Sharpe ratios. And, the greater the expected return of the underlying asset, the higher the opportunity cost to adopt the DCA as opposed to the LSI Strategy. Yet, the DCA Strategy has its merits. It does indeed systematically lead to a smaller dispersion of the final outcomes, which may reassure the most risk-averse investors. Another benefit of the DCA Strategy is to introduce discipline in the investment process, at least in the timing and regularity of the investments, which may prevent investors from giving free reins to their "animal spirits". One can even go one step further and argue that the DCA Strategy paves the way of least resistance for the man in the street to save money and build up an estate. This being said, chances are that cognitive and behavioral biases only play a mediating role in the current popularity of the DCA Strategy. Recent market developments shed a new light on the DCA Strategy, and suggest that the liquidity profile of its order flow could very well be the key driving factor of its commercial success. In a market sorely missing depth, the DCA Strategy is indeed a great liquidity provision strategy for the retail brokers and/or the wholesalers. It is therefore promoted aggressively to retail investors. The collateral effect is that retail investors looking for an efficient way to build up positions in risky assets securely, could finally end up with more risks than they think/feel, and possibly than they can really stand.
We show that externally-verixable characteristics (inexpensive for a third-party to verify) of traders or orders allow pro"table purchasing of order #ow and internalization. We introduce total trading cost, de"ned as the e!ective half spread plus the broker's per share commission, as a measure of execution quality. We use this measure to reinterpret prior empirical studies of: (1) execution quality across trading venues and (2) cream-skimming by purchasers of order #ow. Finally, we show brokers can use their direct relationships with customers to assess internally-verixable characteristics (inexpensive for direct veri"cation) in order to increase pro"ts extracted from customer orders. 2001 Elsevier Science B.V. All rights reserved.
This paper analyzes the impact of e-commerce on markets where established firms face competition from Internet-based entrants with focused offerings. In particular, we study the retail brokerage sector where the growth of online brokerages and the availability of alternate sources of information and research services have challenged the dominance of traditional brokerages. We develop a stylized game-theoretic model to analyze the impact of competition between an incumbent full- service brokerage firm with a bundled offering of research services and trade execution and an online entrant offering just trade execution. We find that as consumers' willingness-to-pay for research declines, the incumbent finds it optimal to unbundle its offering when competing with the online entrant. We also find that the online entrant chooses a lower quality of trade execution when faced with direct competition from the incumbent's unbundled offering. The analytical model motivates a unique field experiment placing actual simultaneous trades with traditional full-service and online brokers, to compare order handling practices and the quality of trade execution. In keeping with our analytical results, our empirical findings show a significant difference in the quality of execution between online brokerages and their full-service counterparts. We discuss the relevance of our findings for quality differentiation, price convergence and profit decline in a variety of markets where traditional incumbents are faced with changes in the competitive landscape as a result of e-commerce.
We provide an easy method to identify marketable retail purchases and sales using recent, publicly available U.S. equity transactions data. Individual stocks with net buying by retail investors outperform stocks with negative imbalances by approximately 10 bps over the following week. Less than half of the predictive power of marketable retail order imbalance is attributable to order flow persistence, while the rest cannot be explained by contrarian trading (proxy for liquidity provision) or public news sentiment. There is suggestive, but only suggestive, evidence that retail marketable orders might contain firm‐level information that is not yet incorporated into prices.
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Using detailed order handling data, we find that institutional brokers who route more orders to affiliated alternative trading systems (ATSs) are associated with lower execution quality (i.e., lower fill rates and higher implementation shortfall costs). To separate clients’ preference for ATSs from brokers’ routing decisions, we confirm these results for orders where brokers have more order handling discretion, matched broker analysis that accounts for ATS usage, matched child orders that account for client intent, and based on an exogenous constraint on ATS venue choice. Our results suggest that increased transparency of order routing practices will improve execution quality.
Consistent with prior literature, we find that average relative effective spreads are higher for venues that pay for order flow (PFOF) than for venues utilizing the maker-taker (MT) model. This relation becomes more nuanced when liquidity fees are incorporated into liquidity cost measures. For the majority of options, PFOF venues offer lower average liquidity costs net of taker fees. Net liquidity costs for the high-priced options, however, are lower for MT venues. Overall, our results suggest that the inclusion of fees and rebates can rationalize the routing of most, but not all, marketable orders to PFOF venues. Copyright © Michael G. Foster School of Business, University of Washington 2016.
We identify retail brokers that seemingly route orders to maximize order flow payments, by selling market orders and sending limit orders to venues paying large liquidity rebates. Angel, Harris, and Spatt argue that such routing may not always be in customers’ best interests. For both proprietary limit order data and a broad sample of trades from TAQ, we document a negative relation between several measures of limit order execution quality and rebate/fee level. This finding suggests that order routing designed to maximize liquidity rebates does not maximize limit order execution quality and thus brokers cannot have it all.
We analyze the role of retail investors in stock pricing using a database uniquely suited for this purpose. The data allow us to address selection bias concerns and to separately examine aggressive (market) and passive (limit) orders. Both aggressive and passive net buying positively predict firms' monthly stock returns with no evidence of return reversal. Only aggressive orders correctly predict firm news, including earnings surprises, suggesting they convey novel cash flow information. Only passive net buying follows negative returns, consistent with traders providing liquidity and benefiting from the reversal of transitory price movements. These actions contribute to market efficiency.
We develop a dynamic model of price competition in broker and dealer markets. With no payment for order flow, a zero-profit equilibrium exists. With payment for order flow, spreads widen to more than compensate for this payment; hence, there is no equilibrium in which market makers earn zero profits. While brokerage commissions for market orders can fall, the total transactions cost to submitting a market order remains positive. Consumer and social welfare are both lower in any equilibrium with payment for order flow; payment for order flow redistributes payoffs from traders who demand liquidity to those who supply it.
Exchange members claim that the professional relationships that evolve on exchange floors yield benefits not easily duplicated by an anonymous exchange mechanism. We show that longstanding relationships between brokers and specialists can mitigate the effects of asymmetric information. Moreover, a specialist who actively attempts to differentiate between informed and uninformed traders can achieve equilibria that Pareto-dominate an equilibrium in which the two types of trades are pooled. Our model also elucidates the role of block trading houses in mitigating information problems in the block market.
The authors analyze the effects of a finite tick size and the practice of 'payment-for-order flow' on market competition. Even if the New York Stock Exchange (NYSE) reservation price is superior to its non-NYSE counterpart, brokers may, because of payment-for-order flow, prefer to execute orders off the NYSE floor. In accordance with the implications of the model, empirical analysis suggests that non-NYSE marketmakers trade a larger fraction of the smaller order sizes and offer fewer price improvement opportunities and that large companies appear to have enhanced price improvement opportunities on the NYSE. Copyright 1995 by University of Chicago Press.
Benveniste et al. J. Financial Econom. 32 (1992) 61–86 argue that repeatedly dealing with the same brokers allows market makers to know when brokers exploit private information. This suggests that broker identity may allow market makers to differentiate between customers when pricing market-making services even when market makers can provide separate quoted prices for each order size. Estimates of a major Nasdaq dealer's gross trading revenue vary substantively among routing brokers after controlling for order size. Furthermore, these differences exhibit a degree of stability over time. This suggests that market makers may effectively enforce clientele pricing schedules in a world where security prices are quoted without a minimum price variation and the limit order book is available to all market participants.
This article compares the bid-ask spread for New York Stock Exchange-NYSE listed securities before and after a major third market broker-dealer, Bernard L. Madoff Investment Securities, begins to selectively purchase and execute orders in those securities. Tests reveal the quoted bid-ask spread tightens when Madoff enters the market. Furthermore, trading costs as measured by the difference between the transaction price and the midpoint of the contemporaneous bid-ask spread do not increase. Together, these results suggest that the adverse selection problem associated with allowing agents to selectively execute orders in exchange-listed securities may be economically insignificant. Copyright 1997 by American Finance Association.
A dynamic model of insider trading with sequential auctions, structured to resemble a sequential equilibrium, is used to examine the informational content of prices, the liquidity characteristics of a speculative market, and the value of private information to an insider. The model has three kinds of traders: a single risk neutral insider, random noise traders, and competitive risk neutral market makers. The insider makes positive profits by exploiting his monopoly power optimally in a dynamic context, where noise trading provides camouflage which conceals his trading from market makers. As the time interval between auctions goes to zero, a limiting model of continuous trading is obtained. In this equilibrium, prices follow Brownian motion, the depth of the market is constant over time, and all private information is incorporated into prices by the end of trading.
We present a model of Nasdaq that includes the two ways in which marketmakers compete for order flow: quotes and direct payments. Brokers in our model can execute small trades through a computerized system, preferencing arrangements with marketmakers, or vertical integration into market making. The comparative statics in our model differ from those of the traditional model of dealer markets, which does not capture important institutional features of Nasdaq. We also show that the empirical evidence is inconsistent with the traditional model, which suggests that preferencing and vertical integration are important components in understanding Nasdaq. Copyright The American Finance Association 1999.
ESMA warns firms and investors about risks arising from payment for order flow and from certain practices by 'zero-commission brokers
- Cfa Institute
Trading Rules, Competition for Order Flow and Market Fragmentation
- Amy Kwan
Price Improvement and Payment for Order Flow: Evidence from a Randomized Controlled Trial
- Charles Lee
Remarks at the 1993 Ray Garrett Law Institute
- Richard Roberts