“Principles for the Development of a Complete Mind: Study the science of art. Study the art of science. Develop your senses – especially learn how to see. Realize that everything connects to everything else.” – Leonardo da Vinci
If there ever was a time to see how things are connected to other things, it is now. This is particularly true in places where something that is “free” is interpreted to be “without cost.” After all, like “free” drinks at the casino, human nature tends to regress to its most lizard-like tendencies when presented with a frictionless environment…
When will we ever learn that “free” is never the best price?
Anyway, without becoming distracted by a rant about the true cost of Facebook, et al, let’s take a brief look at the impact of “commission-free” trading on the macrostructure of the US market ecosystem over a very short window since October 2019:
Thanks, in large part, to the popularity of retail broker, Robinhood Financial, LLC (“Robinhood) – the upstart financial casino targeted at underemployed millennials – at a time when heavily-armed alpha seekers are trying to squeeze the last few pennies of uncollateralized lunch money out of whatever is left of our economy, a number of proverbial billiard balls have found their intended pockets in relatively quick succession.
Within 24 hours of the venerable Charles Schwab announcing commission-free trading on stocks, ETFs and options on October 1, 2019, E*Trade and TD Ameritrade followed suit. Fidelity joined the club within a week.
Alphacution wrote of this episode in “Schwab and Others Confirm Status as Casinos, Purveyors of Financial Opioids” (October 11, 2019) and then attempted to model the business strategy shifts that might make up for the lost commission revenue in “Ch-ch-changes: A Subscription to ‘Charles Ameritrade’” (December 17, 2019).
Now, with a couple of quarterly data prints in the can, we can see where some of that lost commission revenue showed up (through March 2020). The following exhibit represents the individual and total order flow revenues for three of the top retail broker firms (AMTD, ETFC and SCHW) over the 33-quarter period ending Q1 2020 (without factoring in an estimate for Robinhood):
As an example of the other side of these transactions, we can turn to Virtu – the only place where directly observable payments for order flow (PFOF) can be found among this cast of characters. Over the 33-quarter period ending Q1 2020, we find a similar parabolic trend as above, with Virtu incurring a dramatic all-time high of $62 million in PFOF for Q1 2020; a 59.6% increase over the previous all-time high in Q4 2019. Moreover, given company guidance for Q2 2020 based on performance for April and May (through May 31, 2020), PFOF is already estimated by Virtu to be $60 million; thus leading to Alphacution’s estimate of ~$90 million for all of Q2 2020.
For grins and giggles, the following is Virtu’s portion of the total order flow revenue time series:
This next piece is where MEMX – the upstart Members Exchange set to go live later in 2020; backed by the retail brokerage heavyweights (Schwab, TD Ameritrade, E*Trade and Fidelity), sell-side dark pool heavyweights (Goldman Sachs, Morgan Stanley, BAML, JPMorgan and UBS) and a selection of the leading non-bank market making heavyweights (Citadel Securities, Jane Street Capital and Virtu); and touting improvements in design such as “lower pricing on market data, connectivity, and transaction fees” – enters the finale of our trick shot:
With competition approaching an apex for those who dare to harvest structural alpha in closest proximity to the fragmented sources of US listed liquidity, it does not take a brain surgeon to see that something needs to be done about the cost of being profitable in this business. Granted, there are no weeping violins playing in the background of this tale. Most of these players have been handsomely rewarded for skillful navigation of an inconceivably complex environment while so many others have been forced to change course or tap out…
So, where do they battle against costs? Likely in the places where incumbent exchanges have had a lock on those costs, such as “lower pricing on market data, connectivity, and transaction fees.” The exhibit, below, uses Virtu again as an example where data, connectivity and transaction fees are the main areas – other than PFOF – where significant costs could be reduced…
(Note: Market makers can optimize total headcount through process efficiencies and then figure how much “fat to leave on the steak.” This is typically a cultural determinant that defines the ratio of developmental personnel to operational personnel. However, skimping on human capital costs is not likely to lead to a competitively compelling outcome. In a world of highest-performance technology, people are still a critical ingredient in the special sauce.)
One more thing: We took a quick swag at an updated estimate for Robinhood’s portion of total order flow revenue, but wanted to keep it out of the storyboard above, for now. The observable data is sparse, and our overly simple linear model could be improved – at least, in terms of credibility – with factors like overall market liquidity and volatility, among others. That said, these figures show that Robinhood’s impact is potentially significant, with Alphacution initially estimating $42 million in order flow revenue for Q1 2020 and $134 million for 2019.
When we update these figures and other developments, you’ll find it here on the Feed.
Until next time…
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