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In the last quarter, 61% of Robinhood's total PFOF payments came from this one source. It was larger than PFOF from all other sources combined!
In 2020, it generated almost 46% of the TOTAL revenue!
Yet, it is rarely talked about.
Most of the PFOF debate concentrates on the more popular stocks and equities, even though they account for only 26% of the revenue.
Whereas the 46% chunk largely remains neglected…
Let's find out what this PFOF is and why it's so significant.
Under the Radar
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Previously on PFOF…
The common criticism of PFOF is that it incentivises brokers to optimise order rebate payments rather than getting the best price for the client. However, it's a significant source of revenue for brokers and enables them to forgo fees and offer commission-free trading. Good stuff, right?
Well, not really. Since trading is free, it's easier for clients to "overtrade" and take too many unnecessary risks.
On the other hand, brokerages have every reason to encourage this behaviour. The more people trade, the more PFOF a broker receives, resulting in higher revenues and profits.
And if it comes at the cost of someone YOLO'ing their total net worth on Tesla, so be it.
Luckily, retail brokers have their clients’ best interests in mind and limit excessive trading just to stocks. After all, it wouldn’t be right to allow and encourage people to trade significantly riskier products, like options… They are way too risky! Very leveraged. "Financial weapons of mass destruction", as Warren Buffet once called them.
No matter the incentives, the brokers just wouldn't do something like that, right?
It turns out – they would, and they did.
And options became a major source of PFOF revenues for discount brokers.
Wall Street Journal (WSJ) reports that "in the 12 months through June, the 11 largest U.S. retail brokerages collected $2.2 billion for selling customers' options orders [..] That was about 60% higher than their take from selling equities orders."
This is also evident if we look at Robinhood's PFOF breakdown – options has always been a significant source of PFOF payments:
So what drives that?
First of all, let's have a look at Robinhood's Order Routing Public reports, say for September 2021:
The discrepancy in payments is even more evident for TD Ameritrade and Charles Schwab:
That's right – it looks like options offer brokers almost six times more PFOF than stocks. Now it's clear why options make the most significant share of the total PFOF among discount brokerages.
The question is – why would firms like Citadel and Wolverine pay more for option orders than for stock orders?
Partially, it's because of the wider bid-ask spreads on options contracts. These firms are market makers, and they make money from the spread. The wider the spread, the more money can be earned per each buy-sell roundtrip and hence more PFOF they can pay to retail brokers.
But partially, it's due to the specifics of options market structure.
Even Fidelity, which boasts no PFOF payments in equities, accepts PFOF in options because options are "structurally different than equities."
Indeed, they are. The system is designed so that instead of rewarding firms who offer investors the best price, it rewards firms who bring client orders to the exchange, effectively adding another layer of PFOF.
To understand how options market structure works, let's go on an options order trip.
The Lifecycle of an Options Order
Meet Craig. (Yeah, let's go with Craig, why not?)
The options order starts with Craig, who purchases 100 calls on AMC.
He sends this order to his retail broker, Robinhood.
Robinhood, not having exchange connectivity, effectively sells this order to an execution firm, called a wholesaler, such as Citadel. The options market is dominated by only four wholesaler firms, who control about 80% of the retail options flow.
If this was an equities order, Citadel could execute it internally. It would simply offset this order against another one in its inventory, bypassing the exchange altogether – a process is called "internalising".
However, this isn't Vegas, and Craig isn’t buying shares.
Unlike equities, the SEC requires investors' options orders to be executed on an exchange. So even if Citadel has two exactly the same offsetting options orders that can be crossed for a profit, these must be sent to an exchange.
The exchange then runs a price-improvement auction among its market makers (MMs), some of which execute the order.
Craig gets a fill, and Citadel pays PFOF to Robinhood. The sun is shining, and the weather is sweet. Except that Citadel paid PFOF on an order that it didn't execute but sent to the exchange instead.
But, come on – you didn't really think that Citadel would donate its order to the exchange MMs just like that, did you? 🙂 Because guess what! One of the exchange MMs is…
Or, to be more exact, a Citadel affiliated MM.
It's there to maximise the chances that an order sent by its parent wholesaler is picked up by an affiliate – effectively internalising the order.
And this is what the four leading wholesalers do – they have an affiliated MM on each options exchange.
Why is this a problem? It wouldn't be if there were just one options exchange. However, since there are many, the wholesalers have a choice as to which exchange to route their clients’ orders.
Thus exchanges have to compete for this options order flow, pretty much the same way as wholesalers do. Which exchange a wholesaler routes an order to depends largely on the likelihood of that order being executed by their affiliated MM.
Exchanges know that and have many incentives to "sweeten the deal" for the wholesalers.
These incentives effectively act as a PFOF and reward market makers (MMs) who bring business to the exchange – i.e. the ones with an affiliated wholesaler who supply the retail orders.
Overall, three main programs put affiliated MMs at an advantage:
• Marketing fees
• Response fees (a.k.a. Break-up fees)
• Specialist appointments
Since an exchange is an intermediary, it cannot generate rebate payments from market-making. It must find other sources of revenue to fund its PFOF program, and these come from marketing and break-up fees.
For example, marketing fees are designed to cover the cost of attracting a customer order. These are paid by all MMs and pooled together in a "marketing fee pool". It's then distributed back as a rebate to wholesalers, who route option orders to the exchange.
Effectively, non-affiliated MMs are chipping in to pay wholesalers for their options flow.
The exchange also offers affiliated MMs an advantage during the price improvement auction by charging them only 10% of the fees – $0.05 vs $0.50 per executed contract.
This means that a MM who provided a better price than an affiliated MM is charged an additional fee only to trade the order.
Consequently, this reduces the price improvement that non-affiliated MMs can offer and the investors get a worse fill than they otherwise would.
On top of this, exchanges also run a "specialist" program, where they appoint a dedicated MM for each underlying. Specialist MMs are required to ensure that liquidity is always present and have higher quoting requirements than other MMs.
And for this, they receive even more trade allocation and flow.
Who are these specialist MMs? (Do you really need to ask?)
Optiver reports that "as of May 2021, four MMs with affiliated wholesaler maintain 84% of the 40,000 specialist appointments in underlying symbols across the 11 exchanges that offer such appointments."
These exchange mechanisms place all other MMs at a disadvantage and drive them out of the competition, resulting in a concentrated market, higher internalisation rates, and worse execution.
Best vs Better
Given all these exchange rebates, wholesalers can offer higher rates of PFOF for option orders than for equities.
However, for retail clients, this means that instead of getting the "Best Execution", investors merely get "Better Execution".
The scope for actual price improvement is limited, as exchanges prioritise order flow instead of execution quality and focus more on winning business from the wholesalers rather than serving investors' interests.
If wholesales can exert so much power over the exchanges, it's really up to them to decide how much price improvement to give you.
And given that wholesalers are not charities, they will not leave money on the table.
At least not more than necessary.
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