A new academic paper, which supports payment for order flow (PFOF), has been making the rounds through the market structure circle.  The paper is titled “Commission Savings and Execution Quality for Retail Trades” and was written by two MIT professors and a University of Texas professor.  The first thing we always do before even reading an academic paper is to check to see if the paper was sponsored and if there is a financial arrangement between the authors and the sponsor.  This paper fails that test miserably as demonstrated by footnote #1:

“Disclosure: Some of the data for this paper comes from Robinhood Markets Inc…The authors have a financial relationship with Robinhood. All views expressed in this memo reflect those of the authors and do not necessarily reflect the views of Robinhood.”

Now that we know about this financial arrangement, let’s take a look at the paper and the why the authors think PFOF is good for retail traders.  The paper opens with this overview:

“Using both public and private order and execution data, we debunk some commonly held misconceptions about payment for order flow (PFOF). We find that PFOF has saved retail investors billions in unnecessary fees by allowing broker-dealers like Robinhood to eliminate trading commissions. We also find that retail investors, and especially Robinhood customers, have enjoyed substantial price improvements on trades executed off-exchange and that off-exchange retail trades generally experience better execution quality than trades of similar sizes on public exchanges.”

Well, no surprise there. The authors of a paper, who have a financial relationship with Robinhood, think that PFOF saves billions of dollars for retail investors and Robinhood customers are even better off than other retail broker customers.  Not surprisingly, the authors use the same old arguments about price improvement as measured by the NBBO as their main defense for PFOF:

“During 2020–2021, Robinhood customers benefited from more than $8 billion in price improvement compared to the national best bid and offer prices.”

Price improvement off the NBBO has largely been dismissed because it doesn’t take into account the hidden mid-point orders that exist on many exchanges and ATSs or odd-lot orders that are not posted to the NBBO. In fact, another retail broker called Public just published a paper titled “Delivering on Price Execution Without PFOF” where they state that they deliver better execution quality to their retail customers without the need to accept payment for order flow.  Rather than accepting PFOF from market makers, Public routes their customer orders to lit exchanges and ATSs using a smart order router.  According to Public:

“When a customer submits an order to Public, the SOR first tries to execute that order at the “midpoint” price that is halfway between the Best Bid and Best Offer by scanning venues that are often not included in NBBO, including retail-specific lit venues and alternative trading systems that are designed to pair natural buyers and sellers at the midpoint.

If we are unable to find a NBBO midpoint (or similar) execution during this first sweep, we route to the exchange with the best available posted price (often called the “inside quote”) as well as the highest likelihood of executing the order at or better than the NBBO. Most often, these are high-quality lit exchanges, including Nasdaq and IEX.”

This type of order routing is much more comprehensive but it’s not cheap and requires paying access fees to the trading venues. Robinhood’s business model could not support this type of routing since the access fees would most likely destroy their economics. We’re not sure how long Public can continue offering free commissions but we appreciate their efforts and hope they continue to prove that they can achieve better execution without PFOF.

Our Thoughts

We first were made aware of the MIT paper by a friend who pointed us to an Axios article by Felix Salmon which featured the paper. Normally, we tend to find these papers before the press picks up on them so we were kind of surprised that Axios featured the article.  Then we thought about it and realized that Robinhood was probably reaching out to their friends in the media to highlight the piece. We then started noticing some more media folks tweeting out the paper and praising it because it was written by MIT faculty.

Robinhood was supposed to be different.  They were going to “democratize access” to the markets. They were the broker to the millennials. But what have they really done?

They have hired ex-regulators for senior executive roles, they have lobbied DC lawmakers to protect the conflicted PFOF model, they have courted some friendly media personalities to push their propaganda and they have paid some academics to support their PFOF claims. It sounds like Robinhood is playing from the big Pharma and major Wall Street firm handbook now.