Rise of Retail Army Shrouds Half of U.S. Stock Trading

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Working in Jersey City as a broker to institutional investors, Michael Beth could mostly only watch in awe as the Reddit mob turned GameStop Corp. into the hottest stock on Earth.

It wasn’t always so for Beth and traders like him. The pros his brokerage WallachBeth Capital counts as clients have always been stock-market kingmakers, historically putting them in the mix at pivotal moments.

But the pandemic-era boom in retail trading has diminished their role. Individual investors’ share of trading has jumped to roughly a quarter of volume, according to Bank of America Corp. estimates. Because these orders almost always get executed by electronic market makers -- away from exchanges that display price quotes to the trading public -- the rise of the pipsqueaks has turned Wall Street upside down. More than 50% of trading has been done privately on some recent days -- possibly for the first time ever.

“Because that flow isn’t always accessible to most participants, it’s not necessarily adding liquidity to the overall market,” said Beth, vice president for equity and derivative trading at WallachBeth.

Rise of Retail Army Shrouds Half of U.S. Stock Trading

Beth is not alone in feeling like something important has changed when more than half of stock dealing is arranged in secret. Congress will begin taking a look Thursday with a hearing featuring, among others, Ken Griffin, the billionaire owner of Citadel Securities, the biggest firm that executes retail orders.

Citadel Securities, Virtu Financial Inc. and other so-called internalizers have built up this business by striking deals with all the major retail brokers like Robinhood and Charles Schwab Corp. WallachBeth doesn’t usually interact with the Gen-Z crowd who steered GameStop’s massive boom because those transactions mostly go from the retail broker to the internalizer. Don’t hold your breath expecting those orders to hit the New York Stock Exchange, Nasdaq or some other public venue where others can respond to them.

For years, off-exchange trading usually comprised between 30% and 40% of total U.S. share volume. In the early part of the last decade, much of critics’ angst focused on how dark pools -- private markets usually run by banks that want to keep their clients’ orders in-house -- were siphoning business from NYSE and Nasdaq. But the move to more than 50% started about a year ago in the early stages of the pandemic, fueled by the explosion in retail trading.

“It’s appropriate to ask the question: Is the market still getting the prices right when there are elevated levels of off-exchange activity?” said Justin Schack, partner at Rosenblatt Securities in New York. “If you’re selling your house, you’d want to show it to as many people as possible, not just one or two.”

Price Discovery

A Virtu executive pushed back on the notion that trades handled by his firm and its competitors are done in secret. “Trades, the culmination of price discovery, are reported to the public immediately regardless of where they occur and the algos and order routers that brokers provide to clients should incorporate those established prices in real time,” said Steve Cavoli, global head of execution services at Virtu.

Retail investors have also benefited from faster execution and better prices, said Citadel Securities spokeswoman Julia Kosygina.

For the r/WallStreetBets populists, what happened with GameStop stirs up a whiff of irony: While their frenzied trading has trounced a few storied hedge funds, their activity has swollen profits for a billionaire -- Griffin -- and cemented an oligarchy in serving this new horde of customers.

Still, the new order has helped the small fries. The internalizers pay retail brokerages like Robinhood and Charles Schwab for their flows while promising to fill their orders at the best prices. Citadel Securities says it provided $3 billion in what’s known as price improvement across stocks and options in 2020 by executing trades at prices that were better for the investor than those listed on public exhanges.

With that source of revenue and no need to build their own trading systems, the brokerages can offer commission-free trades to customers.

When an internalizer fills a retail order, it has to do so within the National Best Bid and Offer -- the highest price buyers are willing to pay and lowest price from sellers. This NBBO comes from the bids and offers on public exchanges. So while internalizers piggyback off public quotes, they don’t provide any.

U.S. Representative Trey Hollingsworth, a Republican from Indiana, plans to ask at the Thursday hearing about the rise of off-exchange trading and whether it has a “deleterious impact on price discovery and price transparency in markets,” he said in an interview Tuesday. “We can really start to think through is there a policy answer that needs to be constructed surrounding that or is that just some of the natural growth in the direction of the market?”

While hard to prove, the concern for the likes of Schack is that the bid and offer quotes are becoming less representative for stocks that are retail favorites. And there’s the additional concern that prices aren’t firm. An analysis by Bank of America’s Ana Avramovic found that because less volume is accessible, shortfall costs -- or the gap between a stock’s price when a trader places a buy order and when their trade is executed -- are roughly double in retail-heavy names.

‘Get the Market Moving’

As herds of individual investors descend on a stock -- as happened over and over during the Reddit-fueled revolt in January -- prices can get so volatile that bid-ask spreads start to widen. While a professional stock picker might be deterred by higher trading costs or decide it makes little sense for, say, cinema operator AMC Entertainment Holdings Inc. to trade at a two-year high amid a pandemic, the Robinhood crowd shows few such constraints. And the internalizer’s job is to fill every order.

“They are driving that momentum in an upward direction because if they’re internalizing the flows, they’re not going to keep sitting there at the same price to sell to you,” said Jacob Rappaport, head of equities at StoneX Financial Inc. in Winter Park, Florida. “They’re going to get the market moving.”

All in all, the Reddit army has disrupted a large swath of Wall Street -- all thanks to a few juggernauts with the technology to enable it. Citadel Securities -- which takes in 46% of retail order flows -- reaped a record $6.7 billion last year, nearly double the previous high in 2018, the firm said in an investor presentation.

“Everyone I deal with, whether they’re in this business 10 months or 35 years, told me ‘I’ve never seen anything like this,’” Rappaport said. “You can throw rationale out the window.”

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