The rise of retail: new investment tactics and execution quality

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The recent debate about the execution service on the GameStop stock has brought to the fore the question of “payment for order flow”. We believe these practices create conflicts of interest for the brokers and hedge funds, to the detriment of retail investors.

A new generation of millennials started trading shares during the Covid-19 crisis. These investors are more exchange-savvy and have adopted sophisticated trading strategies. The GameStop case demonstrated that these investors’ new investment tactics could interfere with certain hedge funds’ interests. Many end investors have complained about some US brokers’ decision to restrict their execution service on the GameStop stock and accused them of having mutual interests with hedge funds.

The rise of retail: new investment tactics and execution quality

This debate has brought to the fore the question of “payment for order flow”

Bilateral agreements between brokers and hedge funds or market makers are common practice in the US. Instead of executing a client’s order on a multilateral market, the retail broker will execute it against a single counterparty – often a hedge fund or market maker. In return, the broker will receive financial compensation. Such arrangements are also known as “Payment for Order Flow”. We believe this system creates conflicts of interest for the brokers and are detrimental to retail investors.

The purchaser of the flow faces no competition on the execution price. He could thus avoid the controls exercised by the exchange to guarantee fair trading conditions:

  • management of the execution price,
  • continuous access to trading,
  • neutral and transparent control of extreme volatility,
  • liquidity,
  • etc.

Could this happen in Europe?

Even though European regulators have implemented rules to limit payment for order flow and conflicts of interest, this practice does exist in Europe. While they are not allowed to directly remunerate brokers, trading platforms can act as intermediaries to enable this practice. Brokers and market makers can deal together, with an execution price favourable to the market maker. In return, the trading platform receives substantial financial compensation from the hedge fund, and the execution service on the trading platform is free of charge for the retail broker.

Euronext’s Quantitative Research department conducted a study on the alternative trading platform that retail brokers use the most in Europe. It confirmed that its model goes against interests of retail investors.

A US broker has to communicate on the remuneration it receives from a hedge fund. Yet, the European broker doesn’t have to inform its client that the trading platform it sends its flow to exempts it from any execution cost.

At Euronext, we believe it is essential to inform retail investors that payment for order flow principles can impact the execution quality and price for investors. In January 2021, the AMF published a guide for retail investors explaining how they can know whether a broker sends orders on-exchange or not: amf-france.org.

Read our Quant Research report “Best of Book versus Apex: no free lunch – trading on Apex more costly than on Best of Book.