Hidden cost of free trading? US$34B a year, study says

[Jrinne]

RT,

Whether algo’s are helpful probably depends on the algo and there are a good number of them. This paper mainly addresses the issue of “order price improvement” and I see no suggestion that any algos were ever looked at in this paper.

The only possible generalization that I could see is that some limit orders will be “marketable” limit orders in that they are between the BID/ASK spread and a broker can give “order price improvement” in some of those situations.

I guess I have no data on those limit orders but also no rational reason to think a broker that provides little price improvement for a market order goes out of its way to do so with a marketable limit order.

For a while IB and people at P123 were making claims that IB provided better " order price improvement" that other brokers. This should put that claim to rest at P123. IB may have already stopped making that claim. If not, the claim is less prominent on their web site. Any benefit for algos that may exist is a different topic that is not addressed in the paper. Other issues such as market maker/market taker, loaning shares, cost of commissions etc. also was not addressed, I think.

Jim

[yuvaltaylor]

This is a great paper. And Jim’s parsing of it is very helpful indeed. I’ve never seen data like this, and it’s extremely eye-opening. It also confirms my anecdotal experience with Fidelity and IB. A big thank you to both Chaim and Jim.

[e_hyche]

Indeed, very interesting. I’ve used IB for more than a decade and in recent years I’ve felt that the executions just weren’t that great. Thought I was being paranoid but perhaps not. Also, IB’s high commissions and incessant requests for me to “verify my account information” compound the annoyance.

Regarding IB’s algos, I’ve never used the adaptive algo in particular, but I can generally say that I haven’t found them to be particularly useful. Some seemed no better than simple limit orders (accumulate/distribute), and others frankly seemed terrible (VWAP–the algo would sit idle when spreads were narrow, then trade aggressively once spreads widened). I trade mostly small, low-volume stocks so perhaps they work better on larger companies.

Looks like a change of broker might be in my future. Many thanks to Chaim and Jim for bringing this to my attention.

[SpacemanJones]

That’s interesting. Of the brokers I’ve used - I used to feel like IB had the best executions, but I hadn’t monitored it as closely in the past couple years.

Yuval, based on your comment I’m inferring that you’ve experienced degradation in IB execution performance relative to companies like Fidelity/Schwab? thanks,

[Jrinne]

For me, it was interesting to watch how people wanted to keep believing in Interactive Brokers and kept saying they were good at order price improvement despite a complete lack of evidence (other features like Algos, the ability to loan share etc aside).

For a while there has been absolutely no evidence that interactive brokers was better. for order price improvement and real data could be found on the subject. There have been posts on this topic before (with data). The data was not as definitive as this article but it is also true that there has been a complete lack of any data suggesting that IB was better for order price improvement.

Even IB has been unable to give any data to support their claim and this has been the case for a while. Here is their web site about “SmartRouting.”

They say their statistic are “impressive” in this screenshot. Possibly a term vague enough that it might not be technically false if shown to the SEC.

But then they do not seem to possess any statistics worth presenting on this page. None whatsoever (last line in the screen shot saying how good their statistics are). There are no statistics at all on this page. Link to full page where no actual statistics exist: [url=https://www.interactivebrokers.com/en/trading/smart_routing.php]https://www.interactivebrokers.com/en/trading/smart_routing.php[/url]

TD Ameritrade’s page on the subject for comparison. They have some statistics that they want to share.

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[philjoe]

Wait so people actually use market orders?

[Chipper6]

Some criticisms of the study in this thread on elitetrader:

“FreeGoldRush”:

I wrote software to test order fills at IB and TD. Identical orders were sent within less than 5 ms of each other. IB consistently got better fills that exceeded the commissions and exchange fees you pay at IB.

That’s just my experience. It’s not a study. I’ve sent thousands of orders to IB and seem to get what I expect from them. The TD experience has always been very different.

And from “Fain”:[quote]
I’ve tested against 4 Brokerages in Canada and they came ahead each time.
…
These guys were too broke to do a proper study. Notice the trade sizes are all below a board lot. Could be internalizers get better odd lot fills but Increase the trade size and IB comes out ahead. Didn’t test options, small order sizes, only large cap companies, only US companies.
[/quote]

P.S. Reading that other forum reminded me once again how good the quality of the dialogue on this forum is! This forum is a treasure!

[InmanRoshi]

Yes, maybe the big brokers are better at getting fill improvements on large cap highly liquid US stocks. They might be worse at other things. IB has been used for a lot time in the professional day trading community despite being fairly non-intuitive and a clunky UI (imo), and I assume it’s for a reason. It probably comes down to the right tool for the right user on the specific job.

[Chipper6]

As mentioned, this study was for market orders. I wonder if limit orders would show different results.

[yuvaltaylor]

Yuval, based on your comment I’m inferring that you’ve experienced degradation in IB execution performance relative to companies like Fidelity/Schwab? thanks,

Yes, my anecdotal experience is that I tend to get slightly better fills on Fidelity than on IB. But I may be wrong. I just executed VWAP sell orders on Fidelity and IB for the same stock at the same time and got almost exactly the same fill price. IB got a better fill by 2 basis points.

[yuvaltaylor]

Matt Levine at Bloomberg has an interesting take on this paper:

they find that every wholesaler gives (say) Interactive Brokers orders less price improvement than TD Ameritrade orders. Why? They don’t say! Weird.

Here are two possible explanations, which are a little bit related to each other. One is that retail brokerages are seeking “best execution” for their customers in a sort of aggregate way. [3] They route their orders to wholesalers not by running an individual auction for each trade, but by examining the wholesalers’ overall performance over days or months and sending more orders to wholesalers who provide better total price improvement. But the brokers vary in what they are looking for. For instance, one broker might prefer a wholesaler who provides a lot of price improvement on small orders and less price improvement on large orders (because its customers mostly do small trades); another might prefer one who does better on large orders (because its customers mostly do big trades).

This paper looks at $100 trades, which are pretty small. You could imagine a story that goes like: “TD Ameritrade is the best brokerage for executing small trades, while other brokerages might be better for large trades. But this paper only ranks brokerages on execution of small trades, so it finds that TD Ameritrade is the best.”

The other explanation has to do with what I said at the beginning, about adverse selection and retail orders being more attractive than institutional ones. That is not always and uniformly true. Some retail brokerages have customers who are more institutional-like: They are better informed or trade larger sizes. A wholesaler who trades with those customers will do worse than a wholesaler who trades with smaller and less-informed retail customers. So it will offer them less price improvement. If a brokerage’s orders are riskier and less profitable for wholesalers, those orders will get less price improvement. The fact that the professors’ Interactive Brokers Pro account performed relatively poorly might have something to do with who Interactive Brokers Pro is designed for: pros. If you are a market maker trading with pros, you will charge a higher spread than if you are trading with amateurs. [4]

The basic thing that happens in retail stock trading is that wholesalers are able to segregate the market into institutional orders (on the stock exchange, risky) and retail orders (direct from brokers, less risky), and charge the retail orders less because they are less risky. The implication of this paper might be that they can discriminate more finely: Some retail brokerages have riskier orders than others, so they get charged more.

It’s worth reading the piece in full if you can access it: Some Free Brokers Are Cheaper Than Others - Bloomberg

[Jrinne]

they find that every wholesaler gives (say) Interactive Brokers orders less price improvement than TD Ameritrade orders. Why?

While I like the original paper’s data, its background regarding order flow and payment for order flow is lacking. Likewise, I think Bloomberg’s paper is overly simplistic.

Here is a page the describes order flow at Interactive Brokers for IBKR-Pro: IBKR-Pro Payment for order flow

You find one for any broker. There are a lot of “arrangements” in these legally required disclosures.

For example, Dark Pools which are mentioned in the link above (and used by other brokers). These can be an important source of order price improvement—for market orders, some limit orders and MOST VWAP orders. Some Dark Pools, for variousr reasons (including the level of participation in the Dark Pool), are better than the others.

IBKR may not have access to Fidelity’s Dark Pool (and vice versa). For sure they have no obligation to use each other’s Dark Pool.

But Dark Pools are just one thing that the quoted portion of the Bloomberg article (and the original article) did not mention as being possible causes for the difference.

You can sort through the disclosure yourself and make up your own mind on how some of the “arrangements” might affect the price you get. However it happens that you end up paying more (or less) with a broker, it is no accident.

And yes, with some brokers you can get really fast market orders if that is important to you. You are more likely to notice how large of an order you can make before the price you pay exceeds the NBBO. Some brokers will do better at that than others and last time I looked you can find some serious data on that too.

[RTNL]

Yuval, based on your comment I’m inferring that you’ve experienced degradation in IB execution performance relative to companies like Fidelity/Schwab? thanks,

Yes, my anecdotal experience is that I tend to get slightly better fills on Fidelity than on IB. But I may be wrong. I just executed VWAP sell orders on Fidelity and IB for the same stock at the same time and got almost exactly the same fill price. IB got a better fill by 2 basis points.

Yuval - is VWAP your preferred trading algo on IB? Thanks

[yuvaltaylor]

Yuval - is VWAP your preferred trading algo on IB? Thanks

It depends. For very large orders, yes. Otherwise I go with Relative NBBO Peg via P123.

[Jrinne]

Whichever broker actually does better, a VWAP order is a great opportunity for the broker and possibly for a P123 member.

Above, there is a discussion about the study and the smaller order size used in the study. Even a very large VWAP order will be broken up into smaller orders throughout the day. Often into 100 lot orders if I recall (I tend to use percent-of-volume orders now and I have not looked at the individual trade size). So it is not entirely clear that order size is a consideration for determining which broker has a better VWAP order. The study may be pertinent no matter how large your total VWAP order may be.

At IB, there is the potential for a rebate for being a market-maker on some of those trades, I believe. IB may share some of that rebate with you at times. You may find that IB is the better broker for you, in part because of that.

Presumably other brokers can get a rebate for being a market maker when executing market-maker trades through these exchanges. It is interesting that this does not count as payment-for-order flow it seems.

I have taken the time to look at some of the individual orders at Fidelity (a while ago) and there is order-price-improvement of some of the the individual VWAP orders going through at Fidelity. But it is difficult to quantitate how much total improvement one gets by the end of the day.

VWAP orders would present an opportunity for regular members who do not have computers that can execute tens of thousands of simultaneous orders with multiple brokers (as is done in the study above). The VWAP orders do that randomly (but not simultaneously) throughout the day for you. About 30 VWAP trades with 2 different brokers would be more trades than you would need to reach a conclusion.

So you can find your own definitive answer if you are investing enough for this to matter to you. There is no good reason for you to listen to any of my BS (or anyone else’s).

As far as real data that I have generated myself, I compared Folio Investing to Fidelity (with market orders) before I switched to Fidelity—alternating which broker I placed an order with first (at about the same time). Fidelity won by a huge margin. There was basically no order-price-improvement at Folio Investing for market orders when I looked a this.

My main takeaway from my little study: the difference can be huge which I think confirms what the paper said: there can be an order of magnitude (10X) difference according to the paper. Hmmmm……I think I am going to do a little more than say: “broker X has a lot of customers (and kind of a mystique), so I will use them.”

If anyone does the above study with VWAP trades and wants to share it, please include the commissions as well as any rebates.

[philjoe]

Yuval Be careful with passive NBBO pegs, this can cause you to get toxic fills

[Jrinne]

Here are some details of: Fidelity’s price improvement statistics.

This includes SP500 vs non-SP500 orders and breaks down price-improvement by order sizes which people have expressed an interest above.

This is produced by the Financial Information Forum (FIF). Sadly, Fidelity and 2 Sigma Securities are the only organizations providing information to FIF at this time (there used to be more).

[feldy]

I’ve skimmed the study, and it’s interesting for sure, but there are several reasons why I would take it with a grain of salt and not rush to move all your trading accounts over to TD Ameritrade tomorrow.

1. As Matt Levine noted in his column, the trade sizes of $100 are not just small, but comically small. If one were only ever managing position sizes of $100 with market orders or marketable limit orders, then this study may be pretty representative for them. But even in the Fidelity price improvement report linked above, you can see the price improvement metrics drop as order size increases.

2. Their program is designed to randomly send buy orders for and then liquidate 30 minutes later. This randomized order flow is the definition of uninformed order flow that PFOF providers love and will happily eat up. The more informed, alpha-driven flow would likely not get the same beneficial fills from PFOF participants.

3. They are not doing a fully apples-to-apples comparison across the same date range. Transaction costs can vary greatly over time, so this is a bit of a sin. It looks like they ameliorate this a bit by providing some pairwise broker comparisons across the intersection of their common dates, but as a whole the data consists of different date segments. For example, their IBKR Pro and Lite data is completely disjoint, as it looks like they had a single IBKR account that they just flipped from Pro to Lite in April, so the IBKR data isn’t comparable at all.

4. It looks like they are estimating price improvement metrics and on vs off exchange execution by trying to locate their orders in the TAQ data stream. This seems to be an error prone and non-scalable approach. For example, if they were sending more realistic round lot orders, it would be impossible to pick out their orders reliably from the stream. Likewise, calculating price improvement using the quote that was in effect just before the trade in the TAQ data would skew your results depending on broker latency. The more standard way would be to benchmark the order to the quote at the time of submission or routing decision.

In fact, that’s what I would recommend each person do, if possible – measure their total transaction costs for their own order flow. If you use IBKR, they provide fairly decent transaction cost analysis (TCA) reports for you. Moreover, if you send algorithmic orders, then the cost of the entire order relative to the quote at the time your order was accepted (its arrival price) is shown in the report. It’s not as clean if you are slicing and sending your own limit orders, as the order linkage may not be clear, and the market impact of your manual order working may not be measurable to them – you’d likely have to measure this yourself.

This is another reason I’d encourage P123 to expand their support for the full range of algo orders on IBKR. Arguably the biggest industry standard, the Arrival Price order, is not yet supported. And perhaps more importantly, IBKR supports algo orders for other brokers, notably CSFB, Fox River, and Jefferies, who are well-established in the execution space. Having this wider order support, and the ability to randomize order types would be a huge step up.

[korr123]

Almost no, and I mean literally zero, retail market orders have legal informational edge over the market makers. The SEC legalized the implicit pricing of how dumb retail orders are leading to PFOF. In other words, whoever (Jump, Citadel, Jane St. etc.), can extract the most value from how mispriced your order is gets to fill your order. Why else do they pay the brokerage house for the right to fill your order? As soon as the market maker deems your order to not be mispriced (like, when they think you may win on the trade, the let it go to the exchange for a worse fill). So you should think of it as losing less for only market orders.

In regards to IB, Petterfy rightly believes that minimizing trading costs must lead to routing everything to a central exchange for auction. Of course, we don’t have a central exchange and PFOF routes less to exchanges, which widens the quotes, which artificial leads to better price improvement. Why does this toxic cycle exist? Because that maximizes market maker profits in the age of digitization and penny wide quotes.

TL:DR Don’t place market orders. But if you do, place them at brokerage houses that sell your orders for internalization (i.e never go to an exchange).

[Jrinne]

TL:DR Don’t place market orders. But if you do, place them at brokerage houses that sell your orders for internalization (i.e never go to an exchange).

Korr,

Thank you. Can you expand on this for “marketable limit orders” and also on VWAP orders (and percent-of-volume orders) if this has been an interest of yours? I think a VWAP order is essentially multiple “marketable limit orders” made throughout the day.

I think a marketable limit order MAY get price improvement through internalization at some brokers but also there could be a rebate for being a “market maker” for some of the limit orders (the broker getting some of the rebate) and this could be a factor in where the order is directed. Any data on this in the literature or on the broker’s web sites is limited. E.g., the original paper does not directly address this.

Thank you in advance if you have anything to add with regard to “marketable limit orders” or algorithms like VWAP that may involve a marketable limit order.

Best,

Jim