Ordinary people are piling into the stock market, snapping up shares of well-known companies like Tesla and Apple with a few taps on their phones. The influence of these app-wielding investors on the $30-trillion US stock market is still being debated, but in the meantime they are proving to be very lucrative for professional traders.
Brokerages reported a swell of new account openings as much of the global economy went into lockdown, causing stock markets to swoon. Several factors may be underpinning the surge in new retail traders:
- Buying and selling securities has never been easier, with slick smartphone brokerage apps just a download away.
- Late last year a price war between companies like Charles Schwab and Robinhood drove commission charges to zero, as brokerages lean into other, more controversial, ways of making money.
- Interest rates have plunged as central banks like the Federal Reserve do everything they can to keep their economies churning. With so little money to be made on bonds, the stock market may seem like the only way to go.
- Some investors likely saw the downturn as a chance to get stocks on the cheap.
Does the herd of retail traders partially explain the US stock market’s rally? Equity prices are seemingly defying gravity as the deepest recession since the Great Depression unfolds: After falling off a cliff in March, the S&P 500 Index of big US companies has climbed back up and is trading at about the same level as it was in November.
The conventional wisdom is that the institutional money—pensions, insurance companies, and the like—drives the stock market. But there are signs that retail traders have increased their influence. “It’s probably getting close to the scale of institutional trading, but not quite there,” Phil Mackintosh, chief economist at stock exchange operator Nasdaq. He noted data showing that hedge funds have also been using leverage to amplify their bets, and suggested that their investments, plus that of the retail set, have probably given the market a tailwind.
There are millions of new retail traders. Brokerages Charles Schwab, Interactive Brokers, and TD Ameritrade added more than 1 million new accounts in the first quarter, a 4% increase from the previous period. A year ago that increase was about 1%. Robinhood, a popular brokerage app, said last month that it has added 3 million customer accounts this year, bringing its total to more than 13 million.
Small-time investors who are trading from their sofas might account for some of the uplift in stock prices. But there are also other powerful forces at work. The US government has unleashed more than $2 trillion of support to boost the economy, and economists like Mackintosh think the tab could rise to $4 trillion or more before the crisis is over.
It’s not just the US Congress that’s propping up the economy. The Federal Reserve has prevented the pandemic disruption from spiraling into a financial crisis by stepping up as the lender of last resort. The central bank slashed interest rates, bought trillions of dollars of securities, and has backstopped the corporate bond market for the first time. The scale of fiscal and monetary aid is just about unheard of.
“The market is definitely looking forward and basically ignoring this year’s earnings downcycle,” Mackintosh said. “What’s helping is just the sheer size of the fiscal stimulus. Four or five trillion dollars, when it’s all said and done, is a lot of money being put in the system.”
Go back a decade
One theory is that that bored gamblers, with little access to sports betting thanks to social distancing, are the reason for the explosion in retail trading. Robert Cortright, a former foreign-exchange trader who is now the CEO of DriveWealth, is skeptical. His company provides brokerage for digital wallets like Square’s Cash App and Revolut. He argues that the rise in retail trading has been building up for the better part of a decade.
“This has been a long time coming,” Cortright said. “There’s been a lot more happening than just the fact that Robinhood has gone to zero commissions.”
For Cortright, one of the keys to the retail trading bonanza is the proliferation of more than 2.5 billion smartphones around the globe. That, combined with the rise of electronic markets and growing wealth in emerging economies, means an even bigger wave of retail trading could be building up. As digital wallets like INDmoney in India or Australian brokerage app Stake become popular, Cortright thinks “globalized investing” is taking root.
The US stock market will benefit from this overseas investment money. American brands are well known around the world, and the US equity market is the deepest and most liquid in the world. Cortright said his company is adding around 100,000 new brokerage accounts each week, and about 45% of those are outside the US.
He also thinks the advent of “fractional trading” has been underestimated. Thanks to fractional trading, you don’t need to buy an entire share of Google, which costs about $1,400. Instead you can buy a tiny sliver of the stock, making it much more affordable for new investors to get started. “We’re in the early innings,” he said. “It’s going to continue to grow rapidly over the next five years.”
No free lunch
The retail trading frenzy isn’t without controversy. While it’s easier than ever for regular people to buy stocks, they might be surprised to find out that their trades don’t necessarily end up on a stock exchange—at least, not right away. “When we look at our own markets, we get very little direct order flow from retail brokers today,” said Adena Friedman, CEO of Nasdaq, in a conference call with analysts in October.
Instead of going to an exchange, brokerages likes Charles Schwab, E-trade, Robinhood, and TD Ameritrade typically sell retail orders to high-frequency traders (HFTs)—also known as market makers. These companies have a critical role in trading by providing a steady stream of bids and offers so investors can transact at will. They make money by profiting from spread between the bid and the offer.
When a market maker buys retail orders from a broker—called payment for order flow—it most likely handles those trades internally. As trades flow in from brokerage apps, corporate clients, and institutional traders, those orders are offset against each other. The market maker fills the orders at the best price that would have been available on an exchange and then, if all goes well, pockets the spread. It sends some of the profit to the broker.
Robinhood, for example, was paid about $45 million in March, more than twice what it got in January, for selling customer orders to professional trading companies like Citadel Securities, a sister firm to the hedge fund Citadel, and Virtu.
This setup has its critics, but a report from Greenwich Associates says retail traders are getting better service than ever. High-frequency traders provided savings of $1.3 billion for retail customers in 2018, according to the consultancy.
Neither smart nor large
Market makers covet retail trades because they’re relatively harmless. Large professional investors can move prices when they know things the rest of the market doesn’t (through superior analysis, for example), or when the sheer size of their trades causes stocks to gyrate. When prices bounce around, market makers can end up losing money.
Retail trades are, for the most part, neither smart nor large. Because they’re less likely to send shockwaves through the market, HFTs can, the thinking goes, offer them better prices. Virtu CEO Douglas Cifu said in an earnings call that the company provided more than $300 million of “price improvement” to retail traders during the first four months of 2020.
Not everyone is comfortable with this arrangement. One problem is that it becomes much more difficult for retail traders to know how much they’re paying for brokerage. A flat commission fee is simple to understand. Divining how much expense was embedded in the bid-offer spread, and whether another broker would have offered a better deal, is a more difficult exercise. Former SEC chairwoman Mary Jo White in 2014 raised questions about payment for order flow, saying it “can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed.”
In the meantime, the retail trading boom has been a bonanza for high-frequency traders. Virtu’s earnings from market making—which includes retail as well as institutional investors—soared more than 270% to $653 million during the first quarter from a year earlier. Virtu’s Cifu said in an earnings call in May that retail traders, encouraged by zero commissions, and experienced traders taking advantage of work-from-home setups, have been a “key driver” for its market making business.
That is all to say that while it’s easier than ever for regular people to dive into trading, the professionals are likely to be the ones making the big money.