By Bill Alpert 

Critics of retail brokers like Robinhood Markets condemn those companies for routing customers' orders to market makers like Citadel Securities in exchange for payments. Gary Gensler, the chair of the Securities and Exchange Commission, has suggested banning those payments for order flow, arguing that those customers must be getting worse pricing on their stock trades.

The suspicion is that greater payments to brokers must be offset by less favorable execution prices. But that isn't what a new study finds.

In an Aug. 13 working paper, five finance professors analyzed 85,000 stock trades they made through five leading retail brokers. They did get significantly different pricing through different brokers for identical orders to buy or sell at the current market price.

But their best pricing came from a broker that takes payment for order flow, namely TD Ameritrade, now a unit of Charles Schwab (ticker: SCHW). Fidelity Brokerage, which takes no order payments, got worse prices on the professors' trades than did TD Ameritrade. And its prices were no better than those from the E*Trade unit of Morgan Stanley $(MS)$, which does take payments. Robinhood, which used revenue from order-flow payments to subsidize the industry's first commission-free trading, delivered middle-of-the-pack pricing. Interactive Brokers $(IBKR)$ ranked last in the execution pricing of the professors' orders.

In 2020, TD Ameritrade got $1.15 billion in order flow payments, or some 20% of its revenue. Robinhood got 72% of revenue from such payments in 2020, while E*Trade got 14%.

"There's no relationship in our data between paid order flow and price execution," says Chris Schwarz, a finance professor at the University of California-Irvine, who wrote the paper with his colleague Philippe Jorion, UC-Davis professor Brad Barber, Washington University professor Xing Huang, and UC-Berkeley's Terry Odean.

Since most retail brokers have followed Robinhood's lead in cutting commissions to zero, the cost difference between them today is mainly a matter of how good a price they get on the orders they send for execution at a stock exchange or off-exchange market maker. In the last decade, the brokers have sent a growing portion of their clients' buy and sell orders to be executed at market makers like Virtu Financial $(VIRT)$ and Citadel Securities.

The benefit to clients is that the market makers give better pricing on a particular stock than the figures quoted on stock exchanges -- by executing trades at prices inside of the quoted spread. The result is that retail traders get slightly more per share when selling, and pay slightly less when buying.

With no price improvement, a person buying a stock would pay the offer price at the high end of the quoted spread, while a seller would receive the bid at the bottom end. The best price a trader can expect to get is the midpoint of that spread, but how often that happens varies.

The professors write that they were astonished at the size of the execution-price differences among the various brokers. Sixty-nine percent of the trades executed for Ameritrade were at the midpoint of the quoted spread -- meaning the customer effectively got the transaction done without the market maker taking a cut -- compared with 16% in the Interactive Broker Pro account.

Among the stocks in the study, the average spread between the bid and offer quotes was 16.8 cents, a range with a midpoint of 8.4 cents. On average, Ameritrade achieved a price improvement of 47% of that spread, meaning sellers got a price 7.8 cents above the quoted bid, while buyers paid 7.8 cents below the offer, figures that are all quite near the midpoint. The comparable figure for the Interactive Broker Pro account was 19%, for an average saving of 2.8 cents.

Fidelity and E*trade each averaged price improvement of around 35%, while the figure for Robinhood was 27%.

"U.S. retail traders are really being well treated -- better than in any market in the world," says Jason Clague, who heads trading operations at Schwab, Ameritrade's parent. "The last decade has been a steady drumbeat of constantly improving retail trading outcomes." A recent white paper from Schwab notes that the spreads it obtained on U.S. retail trades have narrowed by 67% in the last 15 years, when compared with the spreads quoted on exchanges.

Fidelity notes that it is the only retail broker that reports its execution performance under a standard that was developed by the industry, but then shirked by other brokers. "We support data driven research on execution quality and have consistently called for greater transparency in retail execution quality to allow investors to determine what broker is best for them," said a Fidelity spokesperson. "We encourage other industry participants to provide a full breadth of execution quality statistics for investors' benefit."

Interactive Brokers, Robinhood, E*Trade, and Virtu didn't immediately provide comments. The SEC declined to comment.

While the study casts doubt on payment for order flow as an explanation for different levels of price-improvement by brokers, what does explain the better prices obtained by some brokers? One explanation may be the differences between different brokers' customers. Along with individual investors, Fidelity also handles accounts for family offices and investment advisors. Interactive Brokers courts savvy, active traders. And Robinhood customers have been shown to trade in herds under the influence of social media.

"The level of price improvement will vary by broker or stocks depending on a number of factors, including the nature of the order flow and types of orders, says Gregg Berman, who heads up market analytics at Citadel Securities. "The paper recognizes the significant price improvement we and other wholesalers provide to retail investors as we compete for broker flow."

Schwarz and his co-authors took great pains to send the same stock trades simultaneously to the five brokers. They traded more than 128 different stocks, across a range of market capitalization, liquidity, and volatility, while making sure to include the retail favorites Tesla $(TSLA)$, Apple $(AAPL)$, Nvidia $(NVDA)$, AMC Entertainment Holdings $(AMC)$, Nio $(NIO)$, Aurora Cannabis $(ACB)$, Bank of America $(BAC)$, Exxon Mobil $(XON)$, Alphabet $(GOOGL)$, and Visa (V).

The professors funded the trading themselves, at considerable cost. Each day-trading account required a minimum balance of $25,000, and the professors' in-and-out trades occurred in the six months between December 2021 and June 2022, when stocks were plunging. "We lost tens of thousands of dollars," says Schwarz.

Funding constraints limited the professors' trades to a few shares per order, on average. That makes their findings hard to extrapolate to the treatment traders can expect on larger orders.

Expensive, self-funded experiments shouldn't be needed to compare the execution prices at brokers and market makers, say the professors. The SEC should standardize disclosure of execution performance data, they argue, but the relevant rules haven't been updated in years. Among other things, the rules take no account of odd-lot orders of less than 100 shares, which now comprise over two-thirds of retail trades.

"It's a study that I wish I had done," says Georgetown University finance professor James Angel, who wasn't involved in the research. "Different brokers do different jobs in execution quality. These differences are not driven solely by payment for order flow."

Write to Bill Alpert at william.alpert@barrons.com

$(END)$ Dow Jones Newswires

August 23, 2022 14:54 ET (18:54 GMT)

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