Payment for Order Flow And Asset Choice

Abstract

Financial technology has drastically expanded access to the stock market. Today, a retail investor can effortlessly trade stocks on a smartphone, access news on social media, and pay zero fees for either service. While the automation of trading has been a decades-long process, the coronavirus pandemic further accelerated this evolution. Robinhood, LLC (a zero-commission brokerage firm) currently reports 18 million users, and earns over 80% of its revenue from payment for order flow (PFOF). These are payments from market makers (such as "Citadel") to brokers (such as "Robinhood"), on the condition that the broker privately routes orders to the market maker, rather than to the public markets. This practice has raised a series of concerns from both market participants and the U.S. Securities and Exchange Commission (SEC), which has a mandate to maintain fair, orderly, and efficient markets. The first concern is that these trades may not receive the best prices. The second is that the practice of routing customer orders away from markets may lead to wider bid-ask spreads on exchanges. The third is that retail brokerages will have incentives to encourage excess trading.Across all these concerns, our paper highlights a novel cross-asset difference between stocks and options. In equity markets, we find that broker routing to wholesalers also benefits retail equity traders, as wholesalers offer smaller bid-ask spreads than the exchanges. Moreover, this occurs even when exchange spreads are at the minimum allowable width, in which case PFOF cannot be leading to artificially wide spreads. In option markets, we find the opposite result: broker routing to wholesalers harms retail option traders. Thanks to quasi-randomized assignments of Designated Market Makers (DMM) across options exchanges, we are able to show that PFOF-paying DMMs are causally associated with wider bid-ask spreads. When we look at the PFOF payments made directly to brokers, we show that a similar cross-asset difference occurs: routing options trades pays brokers substantially more, both in aggregate and per-share, than equity trades. Brokers have more than just an incentive to encourage excess trading of any asset, rather, they have a particular incentive to encourage excess trading of options.This cross-asset difference is magnified by the zero-commission trading environment. From SEC Rule 606 reports, we estimate the typical PFOF paid to a broker for routing a 100 share options trade at 40 cents, while the typical payment for routing a 100 share equity trade is around 20 cents.

Retail Trading in Options and the Rise of the Big Three Wholesalers

“…We start by considering several alternative measures of retail trading in options. The first measure, also proposed by Ernst and Spatt (2022), takes advantage of another way to “internalize” retail orders, facilitated by exchanges. If an order is routed to a market maker who is a Designated/Primary market maker (formerly a specialist) in a ticker and it currently quotes at the NBBO, this market maker has priority to execute, at NBBO, any order of five contracts or fewer in full.…”

“…It is reassuring, however, that in independent contemporaneous work, Ernst and Spatt (2022) rely on the same empirical strategy to classify retail trades in the options market. Their findings are complementary to ours, as they focus on order execution quality and market microstructure.…”

“…None of these papers, however, constructs measures of retail investor trading or, more generally, examines retail investors. In independent contemporaneous work, Ernst and Spatt (2022) and Hendershott, Khan, and Riordan (2022) propose the same method as ours to identify wholesaler trades in the options market. Their main focus is on the price improvement (relative to the best prevailing quotes) achieved by wholesalers.…”

Retail Trading in Options and the Rise of the Big Three Wholesalers

“…We start by considering several alternative measures of retail trading in options. The first measure, also proposed by Ernst and Spatt (2022), takes advantage of another way to "internalize" retail orders, facilitated by exchanges. If an order is routed to a market maker who is a Designated/Primary market maker (formerly a specialist) in a ticker and it currently quotes at the NBBO, this market maker has priority to execute, at NBBO, any order of five contracts or fewer in full.…”