Free trading, but often a catch: NYT

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Fallible
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Free trading, but often a catch: NYT

Post by Fallible » Mon Dec 02, 2019 5:00 pm

How free is free trading? The article notes (boldface mine):
In the space of a few days last month, the price war among the brokerage firms pushed the cost for many trades to nothing at Charles Schwab, TD Ameritrade, E-Trade and Fidelity. Then, this week, Schwab said it would acquire Ameritrade for $26 billion — a deal that demonstrated the importance of market share in an era of cheap investing.

But low-cost investing isn’t always as cheap as it appears. Many companies, in stamping out certain fees, are doing other things that can cost you money — and it’s up to you, dear investor, to figure out what they are
.
https://www.nytimes.com/2019/11/29/your ... 9220191202

Has anyone discovered any of these "catches".
John Bogle on his often bumpy road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

livesoft
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Re: Free trading, but often a catch: NYT

Post by livesoft » Mon Dec 02, 2019 5:13 pm

All the fees outlined were being applied before brokerages offered free trades and are still being applied today. So the "catches" are mostly still there intact.
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pdavi21
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Re: Free trading, but often a catch: NYT

Post by pdavi21 » Mon Dec 02, 2019 5:20 pm

Nope, it's really free. There's no catch.

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jhfenton
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Re: Free trading, but often a catch: NYT

Post by jhfenton » Mon Dec 02, 2019 5:23 pm

pdavi21 wrote:
Mon Dec 02, 2019 5:20 pm
Nope, it's really free. There's no catch.
+1 The only “catch” I see is the potential for worse investor behavior with perceived lower trading costs.

Northern Flicker
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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Mon Dec 02, 2019 5:29 pm

The article and associated links articulated the issues. Suppose 30% of retail investors regularly make a couple of the mistakes articulated. This has greater value to the brokerage than the minimal commission, and 30% of a higher market share is more revenue for the retail brokerage.

One mistake would be using a broker that pays meager interest on their settlement account. The investor may give up more in lost interest on funds awaiting investment or awaiting being spent than they save on the commission of investing the funds or realizing the funds from a sale.

A less visible mistake is using market orders or some stop loss orders that do not fix the price at which the transaction executes. A market maker/wholesale brokerage can schedule their execution so that the investor gets an unfavorable price, enabling the wholesale brokerage/market maker to skim more off the transaction, at the expense of the investor. The wholesale brokers use a pay for order flow arrangement which is really no different from a kickback to the retail broker for directing retail business their way. The article noted that Fidelity and Vanguard do not participate in these arrangements.
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Re: Free trading, but often a catch: NYT

Post by GoldenFinch » Mon Dec 02, 2019 5:33 pm

jhfenton wrote:
Mon Dec 02, 2019 5:23 pm
pdavi21 wrote:
Mon Dec 02, 2019 5:20 pm
Nope, it's really free. There's no catch.
+1 The only “catch” I see is the potential for worse investor behavior with perceived lower trading costs.
My first thought was that there will be an uptick in gambling, I mean market timing, behavior. I’m sure somebody will benefit and that was priced into the decision to go free-trade.

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Re: Free trading, but often a catch: NYT

Post by HEDGEFUNDIE » Mon Dec 02, 2019 5:33 pm

Northern Flicker wrote:
Mon Dec 02, 2019 5:29 pm
A less visible mistake is using market orders or some stop loss orders that do not fix the price at which the transaction executes. A market maker/wholesale brokerage can schedule their execution so that the investor gets an unfavorable price, enabling the wholesale brokerage/market maker to skim more off the transaction, at the expense of the investor. The wholesale brokers use a pay for order flow arrangement which is really no different from a kickback to the retail broker for directing retail business their way. The article noted that Fidelity and Vanguard do not participate in these arrangements.
This results in a better price for the investor, not worse.

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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Mon Dec 02, 2019 5:40 pm

How so?
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Northern Flicker
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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Mon Dec 02, 2019 5:41 pm

Duplicate deleted
Last edited by Northern Flicker on Tue Dec 03, 2019 7:14 pm, edited 1 time in total.
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Re: Free trading, but often a catch: NYT

Post by HEDGEFUNDIE » Mon Dec 02, 2019 6:04 pm

Northern Flicker wrote:
Mon Dec 02, 2019 5:41 pm
How so?
https://www.bloomberg.com/opinion/artic ... dell-again
Payment for order flow really is “one of the most controversial practices on Wall Street,” but the controversy tends to be confused and obfuscated. The basic idea of payment for order flow is that electronic market makers want to be left alone to quietly make the spread: They want to buy stock for $99.99 and sell it at $100.01 and clip two cents on each trade. If their orders are random—if sometimes people buy and sometimes they sell, with no pattern—then that works out well for the market makers. But their big risk is what they call “adverse selection”: Sometimes, when a customer buys 100 shares at $100.01, it then buys another 100 shares at $100.02, and another 100 shares at $100.03, and keeps going until it has bought 10,000 shares and pushed the price up dramatically. The market maker who sold it the first 100 shares—and who is probably now short and needs to go out and buy those shares at a higher price—has been run over.

This is a risk of being a market maker on the public stock exchanges: Sometimes you sell 100 shares to a small retail investor and it’s random noise; other times you sell 100 shares to Fidelity and you get run over. But if a market maker can guarantee that it will only interact with retail customers—if it can filter out big orders from institutional investors—then its risk of adverse selection goes way down. The way the market maker does this is by paying retail brokers to send it their order flow, and promising those brokers that it will execute their orders better than the public markets would. (This is called “price improvement,” and allows the retail brokers to fulfill their obligation to give their customers “best execution.”) So if a stock is quoted at $99.99 bid, $100.01 offered on the public exchanges, the market maker might buy it from retail customers for $99.991 or sell it to them at $100.009. (It’s not usually much price improvement.) It can offer a tighter spread than the public markets—and have money left over to pay the retail brokers—because it doesn’t have to worry about adverse selection. If the retail broker is, say, one designed to let young people day-trade for free on their phones, then those orders are probably particularly valuable, because they are probably particularly random.

...

Retail customers are instantly able to buy stock at a price at least as good as, and usually better than, the best price available in the public markets. And the market makers pay their brokers for the privilege, so the brokers can offer cheaper (even free!) stock trades. They [retail customers] are unambiguously better off than they would be if their brokers didn’t sell their orders.
In other words, retail trades are valuable because they are random (or put less charitably, uninformed). So market makers are willing to pay for this order flow, and in return, they offer market or better pricing for those trades

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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Tue Dec 03, 2019 2:54 am

I don’t think I would use the term that a market maker may get run over by selling 100 shares to Fidelity, but the author is certainly saying that selling 100 shares to a retail investor is more lucrative for the market maker than selling 100 shares of the same security to an institutional investor. That means that the institutional investor is getting the better deal, not the retail investor.

Brokers are required to try to get the best price available for a client, but they also can consider the expected execution time for a trade when selecting where to send a trade request, and can select a less favorable price if they believe they will get a more timely execution. This opens the possibility that the funds kicked back to the retail broker may create a conflict of interest for the retail broker when selecting where to send the trade for execution.

The SEC certainly considers this to be a risk when they recommend that investors be vigilant, and exercise due diligence in this area:
https://www.sec.gov/reportspubs/investor-publications/investorpubstradexechtm.html wrote: If you're comparing firms, ask each how often it gets price improvement on customers' orders. And then consider that information in deciding with which firm you will do business.
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Re: Free trading, but often a catch: NYT

Post by HEDGEFUNDIE » Tue Dec 03, 2019 9:18 am

Northern Flicker wrote:
Tue Dec 03, 2019 2:54 am
I don’t think I would use the term that a market maker may get run over by selling 100 shares to Fidelity, but the author is certainly saying that selling 100 shares to a retail investor is more lucrative for the market maker than selling 100 shares of the same security to an institutional investor. That means that the institutional investor is getting the better deal, not the retail investor.
Incorrect. Why would the institutional investor’s counterparty offer price improvement? Fidelity’s trade is an informed trade that potentially suffers from adverse selection which would hurt the counterparty. Robinhood’s trade does not. That’s why the retail trader is actually getting better execution than the institutional trader, as the article makes clear.
There are two objections to this practice. One is that it is bad for investors whose orders aren’t sold to market makers, the institutional investors who instead trade on public stock exchanges. Payment for order flow fragments the markets, takes retail order flow away from the public stock exchanges, widens out spreads on those exchanges, and, by segregating retail and institutional orders, makes institutional execution worse. This objection is probably true! If you’re a hedge-fund manager, you should dislike payment for order flow, because it makes public markets worse for you. (If you invest through mutual funds, as I do, you should also dislike it, for the same reason.)

The other objection is that payment for order flow is bad for investors whose orders are sold to market makers, the retail investors whose orders never touch the stock exchange. If the market makers are paying to get their orders, surely they are doing something nefarious with them, right? Otherwise why would they pay? This objection seems mostly wrong. Very occasionally there is some evidence of market makers doing naughty stuff with the retail orders that they buy, but for the most part, particularly for simple market orders, the result is straightforward: Retail customers are instantly able to buy stock at a price at least as good as, and usually better than, the best price available in the public markets.

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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Tue Dec 03, 2019 6:56 pm

Incorrect. Why would the institutional investor’s counterparty offer price improvement?
First, the institutional investor deals directly with a wholesale broker, deciding where to send the trade. The retail investor deals with a retail broker who decides where to send the trade on behalf of the retail investor. This may or may not go to the wholesale broker with the most attractively priced offer. Moreover, the institutional investor is a large volume high value customer for the wholesale broker. Front-running them is not worth the potential loss of a high value customer.

Second, the institutional investor will have a professional trading desk that strategizes the most cost-effective trading processes and executes them. Part of this is that they need to execute large volume trades and need to organize a method for doing that in a cost effective manner. They also will not make the mistakes that some retail investors will make that leave them exposed to sub-optimal trade executions.

The benefit of randomness of a package of small trades is that the market maker may be able to fulfill many of them internally. If they can electronically fill sequences of small trades internally, this is cost effective and would be a legitimate source of extra revenue to kick back to the retail broker who sends the trades their way. Filling internally also means fast execution, which can give regulatory cover for a less than fully scrupulous retail broker to send a trade to a wholesale broker with a suboptimal price to get the kickback. Of course, paying a commission to the retail broker for a trade does not protect against this.
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Fallible
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Re: Free trading, but often a catch: NYT

Post by Fallible » Tue Dec 03, 2019 8:52 pm

GoldenFinch wrote:
Mon Dec 02, 2019 5:33 pm
jhfenton wrote:
Mon Dec 02, 2019 5:23 pm
pdavi21 wrote:
Mon Dec 02, 2019 5:20 pm
Nope, it's really free. There's no catch.
+1 The only “catch” I see is the potential for worse investor behavior with perceived lower trading costs.
My first thought was that there will be an uptick in gambling, I mean market timing, behavior. I’m sure somebody will benefit and that was priced into the decision to go free-trade.
I generally agree with both posts. It's s a different kind of "catch" jhfenton refers to, but that "worse investor behavior" would be more likely if they don't know how some companies, in going "free," can cost them money. The article shows them "helpful places to look: the way your brokerage uses your cash holdings; the costs of other services it offers; and how it might be profiting off your free trades by getting someone else to pay for them instead."

And this kind of information is important for consumers of any "free" services, not just trading.
John Bogle on his often bumpy road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

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Re: Free trading, but often a catch: NYT

Post by gasman » Tue Dec 03, 2019 8:57 pm

I have a Schwab 401k brokerage window with my employer. It offers "free" trades. The sweep account pays about 0.5%... well below many MM rates.
Seems like the catch.

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Re: Free trading, but often a catch: NYT

Post by cheezit » Tue Dec 03, 2019 9:03 pm

I don't know whether paid order flow is any worse than unpaid order flow if you're worried about front-running. There have been a number of fines in recent years for brokerages front-running their own customers without necessarily selling the order flow, and at least one instance where an institution advertised a dark pool that later turned out to be fake.

My view is that this is small potatoes compared to the 5% front-end loads on mutual funds that used to be totally normal, or even the unavoidable spread losses before decimalization less than two decades ago.

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Re: Free trading, but often a catch: NYT

Post by retired@50 » Tue Dec 03, 2019 9:10 pm

gasman wrote:
Tue Dec 03, 2019 8:57 pm
I have a Schwab 401k brokerage window with my employer. It offers "free" trades. The sweep account pays about 0.5%... well below many MM rates.
Seems like the catch.
It definitely is the catch. See article by Jason Zweig.

https://jasonzweig.com/your-stock-trade ... in-chains/

Regards,

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Re: Free trading, but often a catch: NYT

Post by Tanelorn » Wed Dec 04, 2019 7:30 am

Free trades via payment for order flow results in wider spreads and slower execution times for retail orders. Market makers exploit both of these to make money off retail orders by giving them selectively worse prices / fills. Hedge funds like Citadel aren’t doing this “for free”. Remember, if you’re not the paying customer, you’re the product and don’t expect anyone to look after your interests (except maybe the sleepy regulators).

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Re: Free trading, but often a catch: NYT

Post by beyou » Wed Dec 04, 2019 7:47 am

Not a catch, they will try to sell you managed acct services just as Vanguard is pushing PAS harder now than in the past. They realize that the majority of individual investors play for a while and lose interest or get fearful after losses. At that point you need something else to sell them, or they leave for bank CDs etc. So they are giving away highly variable income in exchange for consistent income and hopefully sticky clients.

Just say no ;-)

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Re: Free trading, but often a catch: NYT

Post by HEDGEFUNDIE » Wed Dec 04, 2019 8:45 am

Tanelorn wrote:
Wed Dec 04, 2019 7:30 am
Free trades via payment for order flow results in wider spreads and slower execution times for retail orders. Market makers exploit both of these to make money off retail orders by giving them selectively worse prices / fills. Hedge funds like Citadel aren’t doing this “for free”. Remember, if you’re not the paying customer, you’re the product and don’t expect anyone to look after your interests (except maybe the sleepy regulators).
It’s actually the other way around. It’s the hedge funds and mutual funds that are getting worse execution as a result of retail orders being funneled to specific market makers.

See Matt Levine article quotes above.

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Re: Free trading, but often a catch: NYT

Post by AlohaJoe » Wed Dec 04, 2019 9:14 am

Tanelorn wrote:
Wed Dec 04, 2019 7:30 am
Free trades via payment for order flow results in wider spreads and slower execution times for retail orders.
The data doesn't support seem to support this.

Schwab sells order flow. Fidelity doesn't.

Schwab execution time: 0.04.
Fidelity execution time: 0.07.

Schwab price improvement on 100-499 shares: $3.50
Fidelity price improvement on 100-499 shares: $2.46

Schwab percentage of shares at NBBO or better: 99.3%
Fidelity percentage of shares at NBBO or better: 98.4%

Surely the argument isn't that Schwab is so much better than Fidelity that they can sell order flow and still execute twice as fast with better price improvement? That makes it sound like Fidelity is completely terrible.

At the end of the day, whether a company does or doesn't sell order flow is irrelevant. All that matters is their actual execution quality. Which you can look up and compare directly, at least for brokers that have adopted the proposed FIF Retail Execution Quality reporting. Unfortunately, Vanguard doesn't believe in showing that level of transparency for their brokerage so we're left guessing about how good (terrible) their execution quality is. :(

ohai
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Re: Free trading, but often a catch: NYT

Post by ohai » Wed Dec 04, 2019 9:25 am

While it is good to be aware of what your brokerage is doing, the article seems to say that brokerages set up these arrangements to make up for lower commissions. In fact, they would be doing this even with high commissions. So, the low commissions themselves are just good for you.

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Re: Free trading, but often a catch: NYT

Post by aristotelian » Wed Dec 04, 2019 11:20 am

One catch is lower return on uninvested cash which in effect amounts to a hidden fee. Fidelity Government MM has 1.34% yield with 0.38% ER, vs Vanguard 1.62% yield with 0.11% ER. Multiplied over millions of customers, Fidelity and Schwab are still making money even if they aren't charging commissions on ETF's.

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Re: Free trading, but often a catch: NYT

Post by Northern Flicker » Wed Dec 04, 2019 5:55 pm


look after your interests (except maybe the sleepy regulators).
It’s actually the other way around. It’s the hedge funds and mutual funds that are getting worse execution as a result of retail orders being funneled to specific market makers.

See Matt Levine article quotes above.
I trust the info published on the SEC web site more than what is an opinion piece by a financial journalist. I can’t speak to the hedge fund industry, but mutual fund companies don’t hand their trades off to retail brokers so that the retail brokers can decide how to execute them. It is virtually impossible to evaluate the transaction cost of mutual fund trades, however, because of soft-dollar arrangements with the brokers.

Moreover, Matt Levine suggested that the market makers get “run over” by the institutional investors, hardly the language one would use if the institutional investors are getting inferior execution.

The relevant question however is not how well the mutual funds or hedge funds are doing, but whether individual investors are getting a good deal on their trades, and what sort of due diligence should be exercised. If you submit orders with an execution price, and your broker never finds a better price for you, particularly for volatile assets like equity ETFs, then it is unlikely you are getting a fair deal, per the SEC as referenced above.
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