Over the past decade, Wall Street has experienced a boom in retail stock trading. Transactions by individual investors have fallen from around 10% of overall market volume in 2010 to around 20% today, according to Bloomberg Intelligence.
Much of this growth has been fueled by the advent of commission-free stock trading. It started with brokerages such as Robinhood and Schwab – which is a Marketplace underwriter – but to date, many brokerages have dropped commissions for buying or selling stocks.
This seems to be good news for retail investors. But the chairman of the Securities and Exchange Commission argued that commission-free trading may not be such a good thing.
“Even if the trade is commission-free, that doesn’t mean the trade is actually free,” said Karyn Cavanaugh, chief investment officer of Carolinas Wealth Management.
When brokers offer commission-free trades, what they are really saying is that retail clients will not pay the commission. Instead, brokerages charge someone else.
“And that’s where market makers come in,” Cavanaugh said.
Market makers are big companies that you may not have heard of. They basically serve as stock wholesalers, trying to match buyers with sellers. This ensures that when someone wants to buy a stock, they can find someone else who wants to sell it.
To understand how this works, think of a supermarket. If you’re heading there to buy a box of frozen pizza rolls, you’d expect the store to have worked with the pizza roll wholesaler to make sure the pizza rolls you want are in the frozen section, waiting to be placed in a cart. .
That’s kind of how the stock market works too. In this example, the brokerage allows me to purchase the pizzas by putting me in direct contact with the wholesaler.
“The broker will route the trade to a market maker, who will actually perform the physical execution of the trade,” said Jonathan Macey, a professor at Yale Law School.
The market maker can then earn a few cents for each trade.
“The business model of market makers is not to make a kill on any given trade, it’s to cut a tiny fraction of a penny each time,” said James Angel, professor of finance at the ‘Georgetown University. “But if you do that on a billion actions a day, it adds up.”
To make more money, the pizza roll wholesaler – or market maker – must increase their sales volume. So he makes an offer to the retailer.
“The market maker goes, ‘Hey, I know I can make money on these orders. In fact, I can share some of it with the brokers,’” Angel said.
In other words, the pizza roll wholesaler pays the supermarket for every pizza roll I buy. This is how retail brokers were able to offer commission-free trades.
But if the supermarket essentially receives a referral fee each time it works with the same wholesaler, what if another wholesaler offers a lower price for the pizza rolls? In other words, does the broker have the best interests of retail traders in mind?
“Does the broker work for you? said Angel. “Where does the broker work for [whatever market maker] pays the most for the order? »
Part of SEC Chairman Gary Gensler’s concern is whether wholesale market makers should pay retail brokers.
“Instead of paying your broker to send your order to them, why don’t they just offer Robinhood customers better prices?” said Thomas Ernst, professor of finance at the University of Maryland.
Regulators in the UK and Canada have banned wholesale market makers from paying retail brokers. If that were to happen in the United States, Ernst said brokerages would have to change their commission-free business model.
“Their employees are not volunteers, their computer systems cost money to operate,” Ernst said. “So they would have to find another source of income, like start charging commissions again.”
SEC Chairman Gensler has suggested an open and transparent auction system, where wholesalers bid against each other. The goal is to help retail investors know they are getting the best price for a stock. But so far, the commission has not yet proposed any changes.
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