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No such thing as a free trade: How Robinhood and others really profit from ‘PFOF’—and why it harms the markets

March 2, 2021, 1:00 AM UTC

Doug Atkin and Bernie Madoff were engaged in a screaming match as two senior officials watched in wonder at the Washington, D.C., office of the Securities and Exchange Commission. On this day in 1991, the future Ponzi schemer was there to defend a new practice he had pioneered and that was attracting huge volumes of trades from retail brokers.

It was called “payment for order flow,” known on Wall Street as PFOF.

Atkin, CEO of trailblazing electronic trading platform Instinet, believed that PFOF worked in direct conflict with his mission of getting the best possible prices for the folks buying stocks. “Payment for order flow isn’t right! It should be outlawed!” Atkin yelled at his opponent. “If it’s so good for investors, why are your brokers keeping it secret, instead of advertising to let people know how good this is for them?”

Madoff shot back that PFOF added lots of liquidity to the markets and that he was getting investors the same prices as the “best” quotes posted on the exchanges. “I’m just trying to get more business!” barked Madoff. The brokers were flocking to his firm for good reason––he was the first to pay them big bucks for channeling their trades to a market maker. Why should the SEC ban him from giving those new clients what they want? “I should be able to do whatever I want to get business,” Madoff asserted.

Three decades later, the congressional hearings exploring the GameStop trading frenzy trained a spotlight on the seemingly arcane system that pitted Madoff against Atkin. At the Feb. 18 session of the House Financial Services Committee, no topic was more hotly debated. Put simply, it’s PFOF that enables Robinhood, TD Ameritrade, E*Trade, Schwab, and most other online brokers to charge zero commissions to retail investors. Instead of getting paid directly by the people buying the shares, the brokers sell their orders en masse to market makers that execute the trades. It’s widely accepted that PFOF has played a crucial role in rallying millions of new millennial and Gen Y customers to invest and speculate in equities. That’s spawning the mass, Reddit-driven movement that drove beaten-down names such as GameStop, AMC, and BlackBerry to astounding highs in a matter of minutes, only to crash in the days ahead.

The representatives raised the same question that riled Atkin and that the SEC has long pondered: Are the online brokers really getting the best possible prices from those market makers? Or is the retail crowd actually paying hidden, inflated costs in the form of the excessively wide “spreads,” the difference between the “bids,” where the market makers buy, and “offers,” the prices at which they sell?

Rep. Alexandria Ocasio-Cortez (D-N.Y.) taunted Robinhood CEO Vlad Tenev with the query, “Would you commit to voluntarily pass on the proceeds from payment for order flow to Robinhood customers?” No, said Tenev, because it’s PFOF that allows customers to trade for “free.”

Rep. Ritchie Torres (D-N.Y.) got closest to the key issues. At the hearing, he questioned whether the investors were really trading for “free.” Or were they incurring even higher total costs than if they paid commissions and got the lowest-possible trading costs? The reason: the more customers unknowingly pay for trades in the form of wider spreads, the larger the profits the market makers reap. He also broke news by prompting Tenev to disclose that Robinhood garners well over 50% of its revenues from PFOF. On Feb. 18 Torres nailed the paramount issue of where the brokers’ and market makers’ interests truly lie. The danger arises, he said, if “payment for order flow is a perverse incentive for brokerage firms like Robinhood to send orders to trading firms that offer them the highest payment rather than offer the retail investor the best execution.”

Ken Griffin, founder the gigantic market maker Citadel Securities, stated that “payment for order flow had been expressly approved by the SEC and is a customary practice within the industry.” He added, “If they choose to change the rules of the road—we need to drive on the left side versus the right side—that’s fine with us.” Lest anyone think he was damning PFOF with faint praise, Griffin issued a ringing endorsement: “Payment for order flow has been an important source of innovation in the industry.” He also noted, “This has been a big win for American investors.”

In a Feb. 9 blog post, Tenev defended PFOF: “Not only do people now avoid trade commissions, the competition to fill the trade orders often yields them a better price,” he said. “That is what enables Robinhood to offer quality execution in trades.” The day of the hearings, Joe Moglia, former CEO of TD Ameritrade, stated on CNBC that PFOF involves no conflict of interest and that it’s one of the reasons “the retail investor has never had a better environment.” In a recent interview, Doug Cifu, CEO of Virtu Financial, one of the biggest market makers, backed rival Griffin’s view that PFOF has democratized the markets and lowered costs. “The retail customer has benefited from easy access to equity markets on their phones for no fees,” said Cifu. “And they receive a price that is at or better than on an exchange.”

On a mission

Atkin couldn’t disagree more strongly. He spent over 20 years in the stock trading arena on a mission to flatten trading costs by championing electronic communication networks (ECNs) that compete today with the big exchanges. Atkin served as CEO of Instinet, the first big ECN and a model for scores of followers, from 1998 to 2002 (it’s now a unit of Nomura). He’s now cofounder and cochairman of Z-Work, a new SPAC aiming to invest in the gig economy and marketplaces. But Atkin still closely follows the trends in trading, and nothing riles him more than hearing the justifications that Wall Street advances for PFOF, so prominently on display at the GameStop hearings. “Robinhood is a wolf in sheep’s clothing,” he said. “Robinhood and other brokers that get paid for order flow advertise free trading, and while they operate within the legal bounds of best execution, they’re not really getting the best possible prices for customers. Their trades frequently cost customers more in high spreads than if they charged commissions and really stretched to get the best prices. The market makers have no incentive to do better than what’s technically defined as ‘best execution,’ just the opposite.”

Sharing Atkin’s view is Thomas Peterffy, founder and chairman of Interactive Brokers, a firm that does not pay for order flow. “The better the execution, the less money the market maker makes,” he said in a recent interview. “That’s how Wall Street banks make so much money.”

Atkin described to Fortune how the market makers appear to be providing the brokers with the best possible prices, while at the same time frequently pocketing big spreads. The game involves delivering at the best publicly advertised quotes on the exchanges, when the market makers could, in many cases, get a much better deal for Main Street investors. Shrinking the spreads, however, means less profit for the market makers––the “perverse incentive” that Congressman Torres cited.

In part, the PFOF debate is now front and center because a new demographic of everyday Americans are suddenly buying stocks, whether investing to build a nest egg or wagering on a quick win from GameStop. In December of 2019, retail accounted for 13% of all equity trades; a year later, that number had almost doubled to 22.8%. And the sway of the masses was the principal force in lifting the total volume of buying and selling by 55% over those 12 months.

How PFOF works

Atkin described how equity trading is composed of three distinct layers.

The first consists of the customers (the fund managers and retail clients). The second is brokers: Every trade, whether placed by a mutual fund or a schoolteacher, must go through a broker; Schwab and Robinhood are brokers specializing in retail, while big banks like Goldman Sachs and UBS cater to fund managers. The third layer divides into two parts: the exchanges and the market makers. The brokers that handle trades for the major asset managers seek the best prices offered on multiple electronic exchanges, from the NYSE’s Arca to Nasdaq. The funds are hawks in seeking best execution. They deploy sophisticated algorithms showing which exchanges and other trading venuesprovide the lowest costs, and demand that their brokers guide orders to those venues. “The tools they use to track costs are called ‘optimizers,’” said Atkin.

But when people sign in with the apps for Robinhood, E*Trade, TD Ameritrade, and many other online brokers, their buy or sell order doesn’t go directly to an exchange. It’s sent to another intermediary whose main role is handling gigantic volumes of retail trades. Those so-called market makers are firms such as Citadel Securities, Virtu, Two Sigma, and Wolverine. America’s masses place their orders on the Robinhood, Schwab, E*Trade, or another online broker’s app; the brokers then route those orders to the market makers that pay them for order flow. An SEC filing on Robinhood’s website discloses that it collected around $190 million from PFOF in its fourth quarter ended in December.

Atkin explained two ways that the market makers reap profits, both at the expense of small investors. The first: failing to deliver retail investors’ sell orders a price that’s higher than the best public “bid” or finding investors’ buy orders a price that’s that’s lower than the lowest posted “ask.” Market makers could oftentimes get those superior prices but don’t because it reduces their profits. Second, they glean valuable information from seeing all that order flow, enabling them to book big gains by, say, buying Tesla for their own account when they see a flood of orders coming in.

While electronic trading has substantially narrowed bid-ask spreads in recent years, said Atkin, many of the most actively traded stocks have large spreads. That gap gives the market makers latitude in choosing prices at which to buy and sell. The SEC National Best Bid and Offer (NBBO) rule only requires market makers to match the best posted prices, which therefore gives them rich opportunities. Market makers do an extremely large number of trades in-house by matching buyers and sellers or taking the other side of the customer’s trade.

Conflict of interest

Sounds great. The broker charges you and me zero commission, and we get the “best” posted price. Only that’s not how the system works. Look inside at the engine room and you’ll see that the market maker is frequently seeking the best deal not for you and me but for themselves. Atkin pointed out that at mid-afternoon on Feb. 18, the bid-ask spread was 17¢ for GameStop, and around $1 for Google and Amazon.

For Tesla, the bid was $791.84 and the offer $792.40. That put the spread at 56¢. “Say Harry places a buy order for 1,000 shares of Tesla on the app for his online broker and at the same time Mary places a sell order,” said Atkin. “The broker routes Harry’s buy order to its market maker, and Harry buys his stock at $792.40, the lowest publicly displayed ask. Mary’s sell order is filled at $791.784, the highest publicly displayed bid price.” In this example, the broker makes the 56¢ spread in milliseconds.

“The market maker is providing the best legal price, but not the best possible price,” said Atkin. He went on to say that the market makers make money even when they “improve” the execution and fill investors’ orders at better than advertised quotes. Let’s say Harry sells 1,000 shares 10¢ better at $792.30. The market maker still collects a fat 46¢ spread and since there are millions of Tesla buy and sell orders a day, think of the profits the market makers are pocketing.

“Here’s what should happen,” said Atkin. “The broker should send Harry’s buy order to the electronic exchange that it knows will do the best job improving the price. Instead of Harry paying $792.40 per share, the exchange could make a trade “at the middle of the spread,” or $792.12. Harry saves 28¢ a share, or $280. Mary would also do 28¢ better if she sold her stock in the middle of the spread. The market maker’s profit motive is to get the biggest spread, not necessarily the best price.” He noted that the incentives haven’t changed since the Madoff days. “When a broker comes to the market maker requesting narrower spreads, the market makers don’t like it. They tell the brokers, ‘We’ll just pay you a lot less per share for your order flow.’”

The market makers have good reason for buying order flow: It provides lots of valuable information other market participants don’t see, which can generate big trading profits. That’s the second factor that can pit market makers against their clients. “Remember, a market maker is only obligated to provide the best advertised prices at any one point in time,” said Atkin. “Say the best posted prices on XYZ stock are $10.00 bid and an ask at $10.15. The market maker sees a rush of orders for XYZ coming in from the Reddit crowd, but it’s not yet big enough to move the market higher. The key bit of information: The trend suggests a much bigger wave to come. The market maker pounces to buy for its own account at the lowest possible ask price, $10.15. That big purchase drives the spread up to $10.15 and $10.30. When the new retail buy orders come in, the market maker sells them the stock they just bought for their own account at $10.15 for $10.30, 15 cents more then the old best ask of $10.15. The market maker just moved the spread against the broker’s own clients.

“Market makers would have to improve prices out of the kindness of their hearts, because it would mean making less money in many cases,” said Atkin. “That’s how out of whack the incentives are. If the brokers felt good about the practice, they’d be telling their customers. They have a good reason for avoiding transparency and keeping the practice shrouded.” The market makers reap so much money from the practice, he noted, that it seems the practitioners really don’t understand how bad it is for their clients. “I like to quote Upton Sinclair, who wrote, ‘It is difficult to get a man to understand something when his salary depends on his not understanding it.’”

It’s remarkable that a practice that started with Bernie Madoff is still praised and prized by the dukes of Wall Street.

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