Short memories

In 2014, Michael Lewis's attack on high-frequency trading, Flash Boys, was No. 1 for three weeks running on The New York Times' best-sellers list. Lewis argued that the stock market was "rigged" against small investors, because high-frequency traders (or HFTs) had access to data that others lacked.

The public outrage, to put the matter mildly, has dissipated. Six years later, the organisation recommended by Lewis for its refusal to accommodate HFTs, Investors Exchange, accounts for a modest 2.5 per cent of US equity trading volume. Although the company retains its trading platform, it recently abandoned efforts to entice companies to list on its exchange, after attracting only a handful of companies. The revolution will be a long, hard slog, if it occurs at all.

What's more, investors have embraced a company that represents all that Lewis decried: Robinhood. Flash Boys advocated that brokers and stock exchanges price transparently, without subsidising one business segment with fees collected from another. Robinhood, (in)famously, charges its customers no commissions for stock trades. That forgone revenue, of course, must be captured elsewhere. Much of that elsewhere consists of fees paid to Robinhood by HFTs, in return for data about orders placed by Robinhood's 10 million clients.

(The information is anonymous. HFTs receive an order's details, such as a request to sell 500 shares of Microsoft (MSFT), placed at a given date and time, but not the customer's name. Thus, HFTs do not personalize their tactics; their algorithms are based on recognizing general patterns, rather than those of individuals.)

During the first quarter of 2020, Robinhood received US$90 million in order-flow payments, which accounted for an estimated 40 per cent of the company's total revenue. (As Robinhood is privately held, the calculation is not precise.) Robinhood makes most of its money from two sources: 1) the spread between what it earns on its customers' cash accounts and what it pays them in interest; and 2) payments received for divulging client trade requests.

Accepted practices

Robinhood is far from alone, although it is perhaps the most-aggressive participant. A website called The Block, which tracks digital assets, found that in 2018, TD Ameritrade (AMTD) received 36 per cent of its revenue from selling order flows, E-Trade 17 per cent, and Charles Schwab (SCHW) 7 per cent. To my knowledge, all brokers collect order-flow payments from HFTs, to varying degrees. (Vanguard has not for its equity trades, but it has for options transactions.)

Few complain. Some of this acceptance owes to ignorance, as without Lewis to lead the Rebel Alliance, most investors do not realise that order-flow payments occur. Companies bury basic information about such payments in their fine print. The details only appear in an obscure filing called SEC Rule 606. (Not to be confused with Chicago's 606 Trail.)

Ultimately, though, order-flow payments don’t strike many nerves, because brokerage customers have learned not to expect transparency. How can Fidelity afford to offer its Fidelity Zero (FZROX) fund series, which levies no expense ratio whatsoever? Fidelity’s customers don’t know the specific answer, but they realise that somehow, in some fashion, the company must be collecting excess revenue elsewhere. Brokerages, after all, exist to make money.

And the people, by and large, are fine with that arrangement, because it is convenient. One could seek the highest money market yield here, the lowest commission structure there, the cheapest index funds in a third place, a low level of order-flow payments in a fourth, and the largest mutual fund platform in a fifth, thereby assembling a better package of services than would be available through a single broker. But who would wish to do that work?

Up for debate

To be sure, investors would have a different attitude if high-frequency trading were a zero-sum game. If each penny that HFTs earned came from the pockets of individual investors, then by selling order-flow data brokerage firms would be selling their clients down the river. But trading is not necessarily a zero-sum activity. If HFTs bring additional liquidity, thereby lowering bid-ask spreads, they theoretically can profit while also providing benefits to retail shareholders. Everybody wins!

Whether that is the case with HFTs is unclear. Bid-ask spreads paid by individual investors have declined, but they might well have if HFTs never existed. Consequently, some who are close to the scene argue that high-frequency trading has indeed improved investor outcomes, while others dissent. Further complicating the discussion is that many of these observers are interested parties.

No outsider can settle this dispute. I will note, though, that Vanguard would seem to be a useful source. The company mostly serves retail investors, partakes only lightly in selling order-flow data, and has a reputation for protecting the interests of everyday shareholders. And Vanguard has steadily supported high-frequency trading. Per a recent Vanguard publication, "Electronic market makers play a crucial role in providing liquidity (that is, making it easier for investors to buy and sell securities), increasing competition, and reducing transaction costs."

Wrapping up

Journalists cherish transparent pricing. When Lewis addressed high-frequency trading, it was inevitable that he would condemn the practice, because order-flow payments occur behind the scenes. I share his sentiment. For the same reason, I have frequently criticised 12b-1 fees, which use mutual funds to extract shareholder dollars that ultimately go to financial advisors. The process is messy, obscure, misleading. What’s to like?

A great deal, as it turns out. Although 12-1 fees have now fallen into disfavour, they were investors’ preferred method of paying for mutual fund advice for more than 20 years. And the allure of free stock commissions, quietly made possible by subsidies from companies’ other revenue streams, has never been greater. Barring new, incontrovertible evidence that HFTs damage retail investors’ returns, I do not expect this controversy to resurface.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.