http://www.reuters.com/article/us-usa-stocks-probe-exclusive-idUSKCN0Y11CJ This investigation may affect Citadel and KCG's ability to execute against purchased order flow. Since a large percentage of Robinhood's order flow is sold to Citadel and KCG via Apex, this may affect Robinhood's ability to continue with their zero commission business model.
Narrower spreads over the years have provided a benefit to customers but the selling of order flow still restricts the customers to paying the offer and selling the bid....they pay the spread even if it is narrower. The market makers who are paying for the flow pay for market orders and not limit orders which everyone should carefully ponder. Market orders will always give up the spread which is the profit for the dealers. Customers have the same access to the markets today by choosing the correct brokerage conduit. They should deal as the dealers do and attempt to buy bids and sell offers instead of vice versa. It doesn't seem like much but that bid/ask spread is real PNL and should not be ignored. Customers who use services such as Robinhood are paying that spread each time.
I really think brokers are overstepping their duties. They should just take our money to the exchange for us and collect a simple fee.
We would agree. Brokers are simply agents acting on your behalf. Broker Dealers are agents and money makers who traditionally provided liquidity by buying from sellers and then selling to buyers (plus a mark up called the spread) when the buyers and sellers were separated by time and space. This is what the specialists on equity exchanges and marketmakers on commodity DCMs would do as well but they went away when modern telecommunications removed the time and space dislocations between true buyers and sellers. Broker-Dealers are the last great form of intermediation and they do the exact same thing as the Specialists and marketmakers. They buy bids and sell offers. With today's technology that is available to everyone no one should use a market order which does return a fill but only by paying the spread (think tax). Market orders should be made illegal which would remove the incentive to pay for order flow and would result in more buyers and sellers interacting between the spread (on average) with each producing increased yields on their transactions over time as neither will be subject to the dealer intermediation. I think in the future you will have Brokers but not Broker-Dealers.
Interesting post. What do you think will happen to the current Broker-Dealers? Will they shed their "dealer" operations by choice or due to regulations that might restrict their ability to trade against the order flow generated by their "broker" operations?
The dealer model is already under some pressure due to ongoing capital constraints at the banks which is only going to get more restrictive. Large customers are already looking for new sources of liquidity and that will trickle down to the small customers who will eventually start thinking about how to trade efficiently by carefully interacting with the markets using limit orders rather than blundering around using market orders. At that time you get more and more participants looking like professionals as they buy a few more bids and sell a few more offers. Another form of trading that simply feeds the intermediaries profits is in the margin loan business. Why is there such a huge spread between repo rates and margin loans? Each night the dealers amass cash and securities by borrowing in the Repo and Sec Lending markets. They borrow cash at 18 to 22 bps. The next day they loan it out (Primes putting hedge funds into synthetic positions via swap or SSF at a financing rate above their VWAP hedge at around 75 bps. They bought the 'bid' at roughly 20 bps and sold the 'offer' the next day at 75 bps. That is how to make money risk free. So why don't the funds that currently loan the money via repo just source the liquidity to the market place directly and bypass the primes altogether? Why don't the customers seeking these term financing rates trade directly with the true liquidity providers without having to absorb the intermediation tax? When the two sides realize that they can meet directly the dealer model will collapse as they will no longer be needed. The trick will be whether the customers can find the correct conduit to give them access to the newly sourced liquidity. It won't be from the establishment. It will come via an innovator.
I would be surprised if this caused any meaningful changes in the way retail firms offer routing of stock orders.
What I think that option brokers really need is a market scanner that scans the options market and displays only options of traders hitting the mid of the options quotes. Then it will become more like it was when they traded in the pits. I'm suprised this wasn't the first piece of software introduced for online traders.
Themis wrote an excellent article on these "free" brokerages in January already (spoiler alert: they're not really free): http://blog.themistrading.com/2016/01/robin-hood-the-legend-of-internalization/