Have you ever wondered how some brokerage firms are able to charge no fees when executing trades in the US equity market? The recent Finance Magnates London Summit 2023 (FMLS:23) panel dove into the inner workings of zero-commission trading in US equities, a model popularized by companies like Robinhood.

Moderated by Michael Lombardo, the Head of Global Equities at Tradeview Markets, the discussion featured Marcela Aguillon, the Deputy Director of Trading Technology, and Carlos Eduardo Ladino Fagundez, the Director of Trading Technology, both from Tradeview.

How Is Zero-Commission Trading Possible?

The panelists first established that US equities, unlike FX, cannot be traded on a B-book model where brokers take the other side of client trades. Doing so would violate securities regulations. However, brokers like Robinhood utilize "payment for order flow" (PFOF) arrangements, selling client order flow to wholesalers like Virtu and Citadel Securities rather than sending it directly to exchanges.

Wholesalers rely on sophisticated algorithms to find hidden liquidity in off-exchange "dark pools", allowing them to buy at the midpoint of the National Best Bid and Offer spread and sell to Robinhood clients at the offer price. This captures the spread as profit while still providing price improvement versus the lit market. These fractions of pennies add up across billions of shares daily, funding the zero commissions.

"The National Best Bid and Offer (NBBO) in US equities is like the inside market. It's essentially the highest price someone is willing to pay to buy a stock and the lowest price someone is willing to sell it at, quite similar to Forex," commented Lombardo.

The Role of Market Data and Technology Integration

Marcela Aguillon emphasized the critical role of market data in trading, detailing their focus on latency reduction and the integration of C++ for real-time system development.

"We chose this language because it allows for control over the hardware and memory of the servers," Aguillon commented. "These features are crucial for developing real-time systems or applications. In our market data tool, we have significantly reduced latency for stocks."

Carlos Eduardo Ladino Fagundez highlighted the importance of providing real market data to customers without markups or retransmissions, ensuring minimal latency. "Our focus is on providing authentic market data without any markups or retransmission."

Weighing the Pros and Cons

From a retail trader perspective, PFOF delivers zero commissions but is likely not the best execution since orders aren't filled at the midpoint. "Are you really getting the best execution ? Unfortunately, the answer is no," Lombardo explained. Wholesalers counter that by aggregating order flow, spreads are actually tighter.

On the other hand, PFOF brings more hidden liquidity into the market, which can narrow spreads. Also, proponents argue it benefits the overall market by keeping spreads tighter.

From the perspective of legislation, regulators have sought more oversight given conflicts of interest. The UK banned PFOF in 2012 and the EU will follow in 2026. The US is adding regulations like order auction rules and execution score disclosures rather than an outright ban.

"For retail traders, it's important to ask your broker if they pay rebates for adding liquidity, as it indicates a more sophisticated understanding of the market. For brokers, exploring technologies like Vulcan for better order routing and management is advisable," Lombardo concluded.

What's Next?

The panelists discussed proprietary technologies like Tradeview's Vulcan bridge which aggregates liquidity across exchanges and dark pools. If fractional penny pricing emerges from pending US proposals, more price improvement could be achieved. With market structure continually evolving, brokers and traders alike must understand models like PFOF and order routing dynamics in the quest for best execution.