The seeds for a dramatic, unprecedented, and permanent transformation of U.S. listed equity markets were planted long before the volatility spike of March 2020, long before the ensuing year of pandemic lockdown impacts, and even long before the more current meme-stock craze of 2021. What these markets have been through - and will continue to go through - is based on a convergence of factors.
The core building block for this transformation - a practice now known to the most casual market observer as payment for order flow (PFOF) - had already been in place since the 1990's. But while PFOF makes this market frenzy possible, it doesn't do so alone. Trade workflow automation and the application of high-performance technologies to streaming market data was already providing significant competitive advantages to early quant traders by the late 1990's.
Liquidity fragmentation - particularly off-exchange (or, dark) trading - was born in the wake of Regulation ATS in 1998. And rules around topics like best execution and conditions for minimum spread sizes resulted from the implementation of Regulation NMS in 2005.
In fact, the post-Global Financial Crisis (GFC) regulatory environment played a role in this transformation, as well. In that environment, bank-owned brokerage arms - the incumbent trading powerhouses on Wall Street at the time - struggled to justify the technology budgets, attract the talent, and summon the vision necessary to compete with the growing capabilities of proprietary trading firms (all of which, high-frequency trading firms) wielding industrialized versions of high-performance technologies in U.S. listed markets. They still struggle, with many Wall Street banks retrenching or exiting their market making operations in equities, particularly retail options.
It took a group of young innovators, not long after their completion of undergraduate degrees from Stanford - with a small dose of New York-style trading perspective and a large dose of Silicon Valley-style design perspective - to harness these factors with the critical addition of mobile technology and highly-gamified social media techniques. What started as Chronos Research as of August 2011 - with its mission to provide turnkey high-frequency trading platforms- rapidly became Robinhood by April 2013. Not long thereafter, by December 2013, a $3 million venture capital seed round set the stage for much bigger things to come.
The concept was to introduce a mobile app centered around commission-free trading. This occurred by March 2015. What the founders didn't expect - nor were they ever quite prepared for - was that the launch of a new (and aggressive) brokerage business model would eventually be mimicked by the largest incumbents, thereby forever altering the U.S. stock market, and disrupting market participants throughout the capital markets ecosystem; a very Robinhood-like maneuver.
Although the historical details are colorful, the story we are about to tell here is not nearly as much about Robinhood The Company or the RobinhoodApp as much as it's about Robinhood The Catalyst. The data shows that a convergence of factors - the growing adoption and importance of PFOF, the gradual growth in off-exchange trading (and the regulatory arbitrage exploited by proprietary market makers that came with it), the shift in the balance of power from bank-owned market makers to those proprietary market makers (a subset of which known in this space as wholesalers), and the increasing effectiveness of social media-style design techniques, among other factors - contributed to an evolutionary shift in retail interaction with U.S. equity markets dating back to before the RobinhoodApp was conceived.
All that said, Robinhood's aggressive version of the commission-free business model - eventually with added tweaks and twists such as PFOF rates tethered to spreads, no account minimums, stock giveaways, and other unique features - fueled its dramatic growth, ultimately attracting the attention of the largest retail brokerage incumbents and triggering them into adopting the central key to their success: Commission-free trading. Welcome to October 2019.
Order routing revenue is one side of a coin that includes trading activity on the other. They are tied together. If one is up, the other should be expected to be up, as well. Exhibits 2 and 3, below, illustrate this relationship and timing for TD Ameritrade and E*Trade, respectively. Both leading PFOF-receiving retail brokers see new highs in trading activity immediately after adopting the commission-free brokerage model, but before the pandemic lockdown and volatility spike of March 2020.
The early impacts of the industry-wide shift to a commission-free brokerage model show up on the wholesale market making side, as well. In Exhibit 4, below, the publisher presents the available data for net price improvement value for Citadel Securities over a 75-month span of time beginning October 2014 and ending - with a few gaps in the data - December 2020. Here, January and February 2020 clearly show new highs in total executed shares, which is the other side of the order flow from retail brokers.
Whereas, in comparison to Interactive Brokers (IBKR) - a trading platform ("IBKR Pro") designed for professional traders that launched a zero-commission version of that platform ("IBKR Lite") in September 2019 - the timing of new high levels of trading activity do not follow the same pattern as the leading retail brokers (see Exhibit 5, below). This is evidence that commission-free trading mainly impacted a certain demographic of order flow before that phenomenon was obfuscated by the early onset of pandemic-induced market volatility.
With that opening as backdrop, the goal with this case study is to provide 1) a detailed analysis of the factors that drive the commission-free retail brokerage model, 2) the role of wholesale market makers in those factors; 3) how wholesale market makers are the primary beneficiaries of that model, and 4) the long-term impacts of that model on the entire capital markets ecosystem.