Zero-Commission Trading: From Hero to Zero
I was originally going to call this post “Ceci n'est pas une GameStop Post”, since it is a post inspired by GameStop but not really about GameStop. But after double-checking Wikipedia to make sure I was using this reference correctly (I wasn’t), I realized I should avoid trying to appear cultured and stick with references I am fairly certain I understand.
With that said, I have no desire to discuss GameStop, as I don’t think I have much to add. (I may be selling myself short, but please don’t tell the Reddit guys! Haha.). But I came across an extremely timely paper on the broader effect zero commission trading has on markets. And given the current debate, I thought it might be useful to summarize some of the authors’ findings.
The rise of “zero commission” retail trading – and its remarkable impact on markets recently – has been quite stunning. Who would have thought that, in the midst of a pandemic, more people would decide to take a flyer into the world of online trading, let alone stage a populist attack on short sellers using GameStop as its battlefield. I personally have had numerous friends and acquaintances – none of which have any investing knowledge at all let alone money to burn – ask for my opinion in the last week or two alone on my views of the best online brokers (“Is Robinhood safe?”) or investing advice (“is now the time to buy Tesla?”). As one put it, they were hoping to put their “stimmy” to work! Each time I’m asked, my mind races back to an old cartoon I saw when I was a kid. In it, the lead character (Fred Flintstone!) asks a seasoned gambler for a tip on the horse races, to which the gambler replies “You want a tip? Don’t Bet on the Races!”. But nevertheless, each and every one of them is in the market now, buying and selling their little hearts out, thanks largely to the new world of “zero commission trading”.
With explicit commissions falling to zero and the ease of trading increasing so dramatically, the big question is: what impact is this having on markets? This is not a new question. Research on this topic goes back more than 20 years. But trading now is much different than it was even just a few years ago. Brokers like Robinhood are providing zero commission trading to traders who often communicate en masse via message boards, making their trading highly coordinated.
Thankfully, a recent – and remarkably well-timed – academic paper sheds light on whether zero commission trading is beneficial or harmful to market quality, as gauged by spreads, volatility, etc. On one hand, the academic literature suggests that “uninformed” retail traders effectively subsidizing aggregate liquidity and price discovery, by providing profits to liquidity providers and informed traders. Therefore, zero commission trading should lead to improved market quality, as it increases participation by retail traders. On the other hand, having these uninformed orders pinging and ponging in markets – especially if done in an (intentionally or unintentionally) coordinated manner via things like message boards – could add “noise” to the market, hampering price discovery, increasing volatility, and potentially stressing dealer inventories when the flows become heavily one-sided. These effects could manifest themselves in the form of higher spreads, as liquidity providers seek greater compensation for the increased risk.
To address this question, the authors create a proxy for stocks with high degrees of zero commission trading, like that done in Robinhood. They do this by – wait for it – identifying which stocks have a relatively large number of mentions on Reddit WallStreetBets! Without going too deep into detail on methodology, the authors compare the market quality of stocks with a large number of mentions on WallStreetBets to those with less mentions, focusing extensively on periods when Robinhood’s trading platform was down. By looking at times when Robinhood traders were unable to submit orders, the authors are able to tease out how markets adapt to the absence of a good chunk of zero commission flows.
Interestingly, the authors find that both quoted and effective spreads are smaller when Robinhood experiences an outage. For other traders, then, the cost of trading appears to fall when Robinhood is down. So, even with a large number of “uninformed” traders out of the market and unable to provide profits to wholesalers (and Robinhood!) and to more informed traders (e.g., HFTs), the net effect on spreads is favorable.
Furthermore, the authors find that volatility is lower when Robinhood is down, reducing execution price risk to other traders. Again, this is consistent with the notion that Robinhood flows, while individually benign in an information (i.e., adverse selection) sense, seem to lead to larger and/or more frequent price movements in aggregate.
Of course, in the presence of GameStop, these results seem somewhat obvious. I seemingly just took 3-4 minutes to tell you that Robinhood trading could have harmful effects on markets, something you could have learned by watching The View the last few days. But GameStop is an anomaly. In some sense, it tells us of the risk of zero commission trading and how it can distort markets in the most extreme ways. But it doesn’t speak to how zero commission trading impacts market quality in less extreme settings. This new academic research answers this question. And when the GameStop genie is put back in the bottle, the results suggest that zero commission trading may continue to have negative consequences on market quality more generally.
Footnotes  For you microstructure buff, I refer you to Battalio (1997) “Third Market Broker-Dealers: Cost Competitors or Cream Skimmers?” that interestingly focuses on Bernard L. Madoff Investment Securities.  See “Zero-Commission Individual Investors, High Frequency Traders, and Stock Market Quality” by Eaton, Green, Roseman, and Wu, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3776874.
The author is the Founder and President of The Bacidore Group, LLC and author of the new book Algorithmic Trading: A Practitioner's Guide. For more information on how the Bacidore Group can help improve trading performance as well as measure that performance, please feel free to contact us at email@example.com or via our webpage www.bacidore.com.
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