This is a 2-part post on market data fees, data sourcing and real-time vs. delayed stock quotes. In part 1, we’re going to break down Payment for Order Flow and the hidden fees and broker revenue streams coming from Alternative Trading Systems and how this unwittingly affects investors.
From Rotary to Right Away (Sort of)
Gone are the days when grandpa would read the stock tables in the back of the Wall Street Journal and dial up his broker to place a trade. At the end of the last century, Yahoo! Finance pioneered providing the stock tables online with 15-minute delayed quotes. Since that time, there’s been considerable innovation in data delivery mechanisms and a massive influx of new competition changing the underlying economics, both of which have created derivative value being extracted in the form of Payment for Order Flow (PFOF.)
The 411 on PFOF
Let’s say Beth wants to buy or sell stock through her brokerage account. She places the trade online and assumes it goes by way of broker to the NYSE. However, because of PFOF, the trade is likely being processed through an electronic wholesale firm who pays her brokerage for the right to execute this trade on her behalf. These payments result in a conflict of interest between the firm and its client by incentivising the firm to execute its client orders with counterparties willing to pay the highest commission and so undermine the firm’s ability to act as a good agent.
As we see from the chart below, the wholesaler is deciding what’s best for the investor without asking them. And, while this practice has lowered trading costs for everyday investors, is it actually in their best interest?
From two to 13…and counting
Market data is a $26Tr business, but until recently, there were two places executing almost 100% of trades – NYSE and NASDAQ. Today, they represent less than half of trades, with the remaining trading volume spread out across 13 other exchanges and 35-40 “dark pools” or Alternative Trading Systems (ATS firms). These ATS firms, such as Citadel, Two Sigma, Virtu and KCG Holdings, were created to let big investors swap large blocks of shares in secret, and have expanded to become a significant part of daily stock trading. In fact, more shares now change hands in dark pools than on the NYSE.
When No Fee is Really Lots of Revenue
Regulation NMS from the SEC requires that anyone working a trade, whether it be an exchange or a dark pool, must report trades back such that it’s included on the SIP quote feeds so this activity is captured in the National Best Bid and Offer (NBBO) presented to all investors. But there’s all kinds of revenue being made from this order flow. Last Fall, Robinhood was slammed in the market as 40% of their revenue came from order flow. During last year’s fourth quarter, regulatory disclosures indicated that they shipped virtually all of their orders for stock trades to four high-speed market makers. The bulk was bought by Citadel, which paid Robinhood an average of “less than $0.0024 per share” on the trades it was routed in that quarter. Those small numbers add up—Robinhood’s users have executed more than $150B in transactions.
As a FinTech unicorn that’s been positioned as anti-Wall St, this was a jarring exposure for many. Vlad Tenev, Robinhood’s CEO and Founder, went on the defensive in a letter to users, stating: “The revenue we receive from these rebates helps us cover the costs of operating our business and allows us to offer commission-free trading. Other brokerages earn rebates and charge you a per-trade commission fee.”
No one is saying that these companies don’t have a right to make money, however, in the age of “fake” news, investors deserve transparency around their information and their trades for the efficacy of their investment decisions. When they believe their trades are being executed a certain way and with their best interests at heart, but the truth is that may not be the case, the potential impact this could have on them can’t be underscored enough.
In part two of this post we’ll dive into the importance of knowing where your market data and quotes comes from the effect of real-time vs. delayed quotes on trading decisions.