I had to read and re-read the email three times. I then found some confirming tweets: IB is indeed removing the $10 monthly inactivity fee it was charging its poor (with less than $100k balance) clients. In 25 years of trading and countless platforms used, I can count on a frog front leg toes how many times a broker sent me a email to notify a reduction in costs. The broking business is any different from an utility provider: they lure you in with a great teaser rate and then slowly grind your costs up until you have enough and decide to jump ship.
It is a great news that the cost revolution started in the US by RobinHood is finally starting to tip its toes in Europe as well. It is also a good opportunity to write about Payment For Order Flow and brokers in general.
The Context
Like any other industry/sector, stock broking competes for profits with other companies in the same value-chain and with clients. When a company finds a more efficient way to deliver a service/product, it has two choices: keep the new margin for itself and increase its profit or lower the cost for its customers, increase its market share and…increase its profit. But this status is only temporary because other companies in the same industry will try to defend their market share, they will lower their customer costs as well and in the end the extra profit will be captured by clients.
Sometimes a sector is shaken up by a new entrant that decides to do things differently or is simply happy with a profit margin lower than that industry average. Think about Ryanair in the European airline sector or Lidl in retailing.
Even if we live in a (almost) global market, local regulations stifle the competitive process. A UK investor cannot use RobinHood not because of physical limitations but because the UK financial regulator, the FCA, does not allow RobinHood to serve UK residents. If you want to have more insights about the different regulatory environments, Meb Faber interviewed FreeTrade co-founder Viktor Nebehaj on his podcast. (Little aside, I cannot understand why start-uppers are using ‘co-founder’ as a job title and not as a matter of fact. If you start a company, you are the founder. If you start a company with someone else, you are a co-founder. If you join a company years after it was incorporated and even raised some funds, you cannot be a co-founder…simply because you did not? It is quite telling how far the cult of entrepreneurship went that now people feel the NEED to be called co-founder, like if it has any additive value to their contribution to the job. I understand the struggle of being at a party and not being able to convey the huge contribution you made to a company in a single word (“I am a co-founder, you know…”) but…aren’t you supposed to be smarter than that?).
A stock broker is a FOR-profit company. Even when it offers all its services (apparently) for free to traders, it has to generate revenues in other ways. Different regulatory environments create different costs for stock brokers. If to the ‘untrained eye’ buying a share of Apple should be a straight forward task, regulations make it quite messy. The same stock can be traded on different exchanges, each one with its particular fee structure.
Exchange A has 10 Apple shares on sales for $99.99 and Exchange B 20 shares for $100.00; to trade on Exchange A cost $1 while to trade on Exchange B cost $.80. Since your broker is charging you a fixed fee, it would prefer to close your trade on Exchange B, even if this will result in a higher execution price for you. In this case your broker might be even sure that giving you the worst price will not mean losing you as a client: your cost is the execution cost plus commissions. If Broker B guarantees you best execution, i.e. it execute your trades at the lowest price it finds no matter his cost, but charges you a commission that is 2 cent higher than Broker A, you are better off getting your share at $100. If local regulation forces your broker to follow best execution, it has to close the trade on Exchange A. If your broker has an agreement to combine orders with another broker to lower fees and the other broker has an order to buy Apple at the same time, they might want to trade on Exchange A because they cost is now $.50 each and they can make their customers happy.
All of this to say that is quite a mess out there, people cannot agree on which regulatory environment is the best, imagine how hard it is to define the best brokerage model. If you want to understand a bit regarding the evolution of the US market in this sense, Flash Boys from Michael Lewis is a great book.
RobinHood
RobinHood entered the field with a completely different business model from traditional online brokers. Zero fees and the gamification of trading lured on the platform million of users that were not trading before: RH cost to acquire a user is very low compared to brokers that in many cases have to still employ a sales force. I use the word ‘user’ and not ‘client’ because if a traditional broker clients are the traders, in the RH case they are the High Frequency Traders, the market makers that pay for its order flow. In order to satisfy its clients, and its business, RH has to be sure that its users trade the most that they can.
This business model created quite an uproar, that I do not find 100% reasonable; putting aside the issues with its customer service (more on this later), if you are able to control your actions, i.e. do not overtrade or use massive leverage, RH is a very useful tool because it lets you trade for free (almost). Commissions, and taxes, represent a huge drag on an investor long term performance and having the possibility to trade for free removes a lot of barriers: you can rebalance your portfolio more frequently and more nimbly, you can diversify more, you can use a wider range of trading models. The fact that you might not get the best execution is still a cost but it is way lower than the commissions traditional brokers were charging before RH; it is not even sure they were giving you best execution in the first place.
It is hard to determine where to draw a line between an effective marketing strategy and a practice that creates a problem for the overall society. A RobinHood user committed suicide last year because RH made him think he owed more than $700k for leveraged trades that went against him. The issue at hand here is not trivial. Should be gambling be legal? Should be cigarettes? On one side credit card fees are clearly exorbitant, on the other no one forces you keep a debit on your card at the end of the month; credit card companies show in big letters their overdraft costs in their ads…but they also do it because the regulator force them to do so. Am I contributing to this community malaise if I pay my AmEx responsibly and enjoy the cashback? We all want to do good but no one should feel bad if it takes advantage of how the current system is designed. You should feel bad if you consider the current system wrong and then vote for politicians that support it, or even worse you do not vote at all.
Controversies aside, RobinHood demonstrated that another business plan for stock broking is possible. Public and FreeTrade have different business models from RH but they all share a common attribute: less costs for their clients.
Payment for Order Flow
Payment for order flow (PFOF) is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. The brokerage firm receives a small payment, usually fractions of a penny per share, as compensation for directing the order to a particular market maker (Investopedia).
Market makers (“MM”) are typically large firms that specialize in a set number of stocks and ETFs, maintaining an inventory of shares or contracts and offering them both to buyers and sellers. Market makers are compensated based on the spread between the bid and ask prices; a key to profitability for a market maker is therefore the ability to play both sides of as many trades as possible. The proliferation of places where stocks are traded changed the way MM make profits; nowadays there is a big overlap between MM and High Frequency Traders: HFT try to arbitrage between different exchanges and doing so they provide liquidity to the market, the classic job of a MM. The difference between a proper market maker and an HFT is that the MM is paid to offer its service but had to offer quotes all the time, irrespective of market conditions, while a HFT can ‘turn off their machines’ whenever they want.
Why Citadel is willing to pay so much for RH order flow? My thesis is because a big portion of RH traders lose money, at least according to past academic studies. Whenever you buy anything on RH, Citadel is taking the opposite side of that trade because is selling you what you want: if they have a reasonable expectation that you are going to lose money on that trade, it makes conversely a good trade for them. Again, reality is way more complicated than that, they are most likely going to close that trade just millisecond after you got hit, if they did not front-run you in the first place (i.e. they bought at a lower price before they sold to you), but knowing that the other side is making a wrong bet is for sure a huge advantage for a MM.
Does all of this matter?
If you are a retail investor trading stocks the answer is no: whatever regulatory environment you are in, whatever that HFT is doing with your order, not paying commissions, or paying less if you are in Europe, is a net positive. There are only two things you have to pay attention to:
- always use LIMIT ORDERs! If you are buying, always define the max price you are willing to pay, no matter what you see on the book. It takes a blink of an eye to have all the quotes to disappear. If you do not do it, you risk to get filled at a price way higher.
- do not load your stop loss orders on your broker system and if you do it (please do not) do not leave the price you are willing to sell blank (see above). I know, this is really annoying, no one likes the alternative of having to stay in front of a laptop all day to check if the market is breaking down. Defining the price of your stop loss also leaves you with the risk of not being filled because the market jumped that quote and you have to sell at a lower price. If you are not willing to accommodate these two things, I suggest you to change trading strategy. You really risk to wake up one morning and see your position gone at a 30% discount compared to where the market is trading.
On the positive side, you can take advantage of above described scenarios! If you have cash sitting around (or unused margin), you can put buy a order at a 30% discount on securities/ETFs you like. If another flash-crash happens, BINGO. These events are pretty rare, if you leave orders around put yourself a reminder every month end (or whatever regular date) to check them.
The real profit machine for RH and Citadel are options. Options are less liquid, so there is more spread for the MM to capture; they also have embedded leverage, so you lose faster all your capital and part if not all of it goes to the MM. As I wrote in multiple other posts, options are really complicated instruments to trade: you need to nail the name, the direction AND the timing of your trade. RH client, Citadel, is voracious about it, so RH push its product, you, to trade them.
It is the same AmEx story: use the card, enjoy the cashback and perks, do not leave an unpaid balance at month end. Here is: trade stocks for free, do not use instruments you do not understand. You can either be the fool or enjoy services that fools are paying for you (long live the fools!).
Customer Service
All these new trading apps have a common trait: a shitty to non-existent customer service. Who would have thought that an algo that is not able to suggest me a decent show on Netflix even if I spend half of my life on it would be able to replace a Primary School educated human being?
The main issue is not that you cannot talk with anyone, is that they have no willingness to solve your problem. Solving problems, 99% of the time generated by the app itself, is a loss of productivity for them, the more time they spend easing your life the less they can dedicate to their next marketing stunt. You are the product, remember? They solve issues for paying clients.
This is the reason why I have Revolut but I never thought to use it as my main bank account. I mean, they are not even good for cross border payments and they were basically born to solve that problem. I transfer some funds in before holidays and then take out whatever is left. When I moved here from Switzerland, and when I moved from Luxembourg to Switzerland, I always used Wise to convert funds and always did it in little tranches. You cannot trust them. You simply cannot.
You have to consider whatever activity you do on these apps as money that can be gone tomorrow…or at least money that you would not be able to access for some months, even if in the past you moved cash in and out seamlessly. Maybe you never had an issue in the past, maybe you will never have in the future…good for you! My suggestion is: use different banks. Keep your pension assets in one place and your trading assets in another. Keep the pension in a traditional bank, a place where trading is relatively expensive (you do not care because you trade once a month) but you know you have a person dedicated to solve your issue/reply your questions. Use the new apps for your fun money, test them and test them until you are sure you can rely on them. Even better, do two and two. Is it a mess to manage? Probably yes. It is redundant? Well, that’s exactly the point. Sometimes there is benefit in being inefficient.
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