Retail investors are incurring billions of hidden costs by using “free” brokers, a study says

Retail investors are incurring billions of hidden costs by using “free” brokers, a study says

Retail investors are incurring billions of hidden costs by using “free” brokers, a study says

Wall Street

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  • Free brokers are still costing retail investors billions, but not because of the controversial PFOF practice.

  • Rather, a new study finds hidden costs stem from differences in price improvement between brokers.

  • This can cause billions in losses per year among all retail investors, the study authors said.

Zero-commission trading apps may have brought a new generation of traders to the stock market, but free brokers have hidden costs that can run into billions of dollars a year for retail investors, according to a new study.

Contrary to what many market experts have said about the use of payment for order flow – the controversial practice that involves routing customer orders to market makers who pay brokerage for such trades – the authors of a new study claim that the rising costs associated with free intermediaries are the result of a different mechanism.

The study, titled “The ‘Actual Retail Price’ of Equity Trades,” published this month by Christopher Schwarz, Brad Barber, Xing Huang, Philippe Jorion and Terrance Odean, argues that it is not market makers who pay for order flow by hindering the best execution for retail businesses, as PFOF critics have said.

Rather, it is the price quality and “price improvement” between brokers themselves that varies, which means that investors can expect to see a different return depending on the trading app they use.

The authors opened accounts with five brokers and conducted 85,000 trades, setting them to run simultaneously whenever possible. The result has been a surprisingly wide range of prices for identical trades compared to the so-called National Best Bid Offer Price, which all brokers claim to be able to beat.

“We find surprisingly large execution differences between brokers,” said the authors, noting that when the brokerage trades directly with market makers, it also allows the brokerage to offer a small price improvement to its users, i.e. customers to sell shares at a slightly higher price or buy shares at slightly lower prices than the market.

And the range of price improvement is a major source of loss for retail investors, depending on the brokerage they do business with. Researchers say TD Ameritrade is at the top when it comes to improving prices, while Robinhood was less competitive in their study.

According to the study, those price differences could lead to billions in losses per year for retail traders.

“We find economically large price execution differences between brokers that, taken together across all retail trades, would potentially add up to tens of billions of dollars in unnecessary annual costs for retail traders … even though we were aware that such trading would not have been “free”, we were surprised by the range of execution prices for our identical simultaneous trades, “the authors said.

Regulators have long been critical of the hidden fees retail traders pay for using commission-free brokers, but their focus has primarily been on the PFOF. The Securities and Exchange Commission, for example, last year slapped Robinhood with a $ 65 million fine for directing client trades to market makers that weren’t offering the best price, and SEC President Gary Gensler recently proposed new rules for greater transparency among brokers who use PFOF to offer free trades to clients.

But the study ultimately argues that the focus on paying for order flow may be out of place.

“We find that PFOF essentially does not explain any of the observed execution differences,” the researchers said. They noted that the practice accounted for only 3.4% of the differences in price improvement between retail brokers.

“Since PFOF does not explain our findings, we turn to market centers to try to uncover the factors that determine the changes in price execution. Eventually, we find that our price differences are due to different brokers obtaining execution prices. different for the same identical trade in the same room “.

Read the original article on Business Insider

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