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German neo-brokers: unfavorable spreads entail hidden costs

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Author: Nico Binnendijk, European Investors-VEB.

The Dutch market regularly attracts new brokers. While there are multiple investment firms vying for investors’ transactions, new players still see opportunities. Trade Republic and Scalable Capital are two German neo-brokers that recently became active in the Netherlands. They offer trading on alternative trading venues, where investors may be worse off in terms of price. How does this work?

Scalable Capital has been open to Dutch investors since September. The firm also offers wealth management, but for Dutch customers only execution-only via Scalable Broker is available. Trade Republic began offering services to investors in the Netherlands in December 2021.

Both brokers neglect an important aspect of investor protection. They are not subject to direct Dutch supervision by the AFM and they are not bindingly affiliated with the Klachteninstituut Financiële Dienstverlening (Kifid, a Dutch financial services complaints authority). For disputes and reporting abuses, investors must go to Germany.

PFOF
Trade Republic and Scalable Capital can be classified as neo-brokers. They want to make investing accessible and often appeal to a young audience. A Dutch example of this is Bux Zero, as it targets a similar audience and is exclusively available via an app. In other respects, it differs from its German peers: in 2021, it didn’t receive payments for routing orders to particular trading venues. Bux Zero has other drawbacks though, as the range of available securities is limited and the possibility to make active investment decisions is curbed.

Last year, the German financial supervisory authority BaFin published a list of some characteristics of neo-brokers. Particularly striking in this is the following point:

  • Compared to established online brokers, they offer only a few trading venues for executing orders. Some even offer only one.

This is the case for Scalable Broker and Trade Republic. Scalable offers trading either through the German exchange Xetra in Frankfurt (for which it always charges investors a commission) and through the alternative trading venue gettex (for which it does not charge investors a commission for particular trades). At Trade Republic, all orders go to Lang & Schwarz (L&S) Exchange. On gettex and L&S Exchange, a single market maker has the sole right to execute orders in a given stock. There is no competition amongst market maker prices or quotes. There are doubts about whether such models – where trades are in effect bilaterally arranged, is consistent with the multilateral definition of exchanges and MTFs under EU rules, and indeed these specialized venues look more like Systematic Internalisers.

The brokers may receive compensation for routing their orders to these trading venues. This is also known as payment for order flow, or PFOF for short. Selling order flow is controversial, because of the wrong incentives it creates. PFOF is banned in the Netherlands, and regulator AFM has long been calling for a ban throughout the European Union.

VEB believes that the reselling of orders violates MiFID II regulations and supports a blanket ban on PFOF. Receiving payments from parties other than the investor creates a conflict of interest, tempting brokers to leave order handling to the highest-bidding party (which does not always offer the most favorable prices for the investor). This may violate the European best execution obligation. Orders should be handled in the best possible way. And indeed, our research shows that on the alternative venues, investors often do not get execution at the best price.

Reselling orders
Many neo-brokers boast about low transaction costs. An important explanation for this can be found in the relationship with alternative trading venues and the market makers active there. Market makers earn their money by realizing part of the difference in buying and selling prices as their own revenue. They also gain an informational advantage from having exclusive access to retail order flow. Orders coming in through a broker are therefore worth money, and they are willing to pay for that.

Scalable Capital and Trade Republic both receive fees from trading partners. We asked the brokers whether they receive payments from market makers for orders from Dutch investors, to which they replied in the affirmative. The brokers operate under a European passport in the Netherlands and they say they are therefore subject to German and European regulations. Although there is no EU-wide PFOF ban, brokers specifically targeting their marketing statements and services to Dutch investors also fall under the ban applicable here.

Due to the entanglement with the trading venues where orders are executed, neo-brokers can offer extended trading hours. The market makers on the PFOF trading venues also issue trading prices when the regular exchanges are closed. The same applies to Tradegate, a venue where trading is possible via brokers DeGiro and LYNX, among others. We therefore take a closer look at order execution on Tradegate as well.

Order execution
How are the results for investors when they place orders through gettex, L&S Exchange or Tradegate? For this, two key features must be considered.

1.            Bid-ask spreads: the difference between the price at which investors can buy (ask price) and sell (bid price) securities. A higher spread means a larger implied cost to investors.

It is prudent to compare the bid and ask price between different trading venues, using truly multilateral exchanges as a reference. For Dutch stocks, for example, these include Euronext and Cboe. It is likely that spreads, especially for less traded shares, are less favorable on the alternative trading venues than on these multilateral exchanges where there is competition amongst participants to set the best prices.

2.            Order book depth. Euronext, Cboe and other multilateral venue operators have a central order book, and the same applies to other national exchanges. In it you can see the best bid and offer prices, including volumes requested or offered. But below that, there is also insight into the depth of the order book – an overview of the orders placed for the stock in question. That information is lacking on gettex, L&S Exchange and Tradegate. All three venues show only the “best” bid and ask price, i.e. the lowest buy price and the highest sell price. L&S Exchange and Tradegate show how many shares are available or in demand at those prices, at gettex even that is not transparent. Investor limit orders are also not public, so important information for price discovery is lost.

The AFM
There have been several studies into the quality of order execution at neo-brokers and their trading venues. This year, for instance, the AFM conducted research into order execution on two PFOF trading venues: Assessing the quality of executions on trading venues.

Briefly, transactions in Dutch shares on PFOF trading venues were compared with those executed on ten other trading venues within the same second.

On the two PFOF venues surveyed, the majority of transactions – 68 to 83 percent – was worse priced than on the relevant reference markets.

German regulator BaFin examined orders in German stocks on four PFOF venues, including Tradegate, gettex and L&S Exchange. The picture is less negative than for Dutch stocks, which is to be expected for these German trading venues that mostly use the Frankfurt Stock Exchange as a reference. Even so, it appears that on average only smaller orders yield favorable execution on the alternative venues.

Above all, the two studies by the regulators make it clear that it matters very much which stock an investor trades in and with what amount.

Primary listing
In order to give a picture of the daily practice for a Dutch investor, VEB took samples of spreads for some major Dutch and American shares on the discussed trading venues and the exchange with the primary listing (primary exchange). The studies mentioned above explicitly compare the PFOF venues with prices on the reference markets in the same second, i.e. during regular trading hours. In this study, we also look at spreads outside regular opening hours of Euronext or Nasdaq.

The table below compares the spreads on the alternative venues with the spread on the primary exchange, for the top ten investments of Dutch individuals in individual shares/certificates according to data from De Nederlandsche Bank. The spreads are typically worse than (or at best, equal to) those on Euronext and Nasdaq, with the exception of one stock on Tradegate and one on L&S Exchange.

Spread: difference between bid- and ask price, divided by the mid-price. The lower the spread, the better. Red: worse than the primary exchange. Green: better than the primary exchange. Blue: equal to the primary exchange. Measurement period: trading days in the week of 31 October. Spreads per security measured at the same moment. Source: websites trading venues and Bloomberg

We see that bid-ask spreads are worse on the alternative venues in the vast majority of cases. A second measuring point during the week of 7 November yields a similar picture.

But when the primary exchange is closed and market makers on the alternative venues no longer have reference prices, some spreads really increase sharply. This is clear for the four Dutch stocks and the U.S. stock in which Dutch individuals have invested the largest amount. Most spreads at least double; the one for Shell on L&S Exchange even widens more than 28 times. Outside trading hours, these implicit trading costs thus become even higher.

Spreads per share during and outside trading hours measured at the same moment. Measurement period: trading days in the week of 31 October. Explanation: 18,8 x means the spread is 18.8 times higher outside trading hours than during trading hours. Source: calculations VEB

Investor in smaller firms
What about an investor trading the shares of five medium-size and small listed Dutch firms? We calculate the average spread on a sample of five AMX-index (Dutch midcap) and five AScX-index (Dutch smallcap) stocks. On L&S Exchange this spread is 88 percent higher than on Euronext. The spreads on Tradegate and gettex are more than twice as high. As a result, for an equal-weighted investment of 10,000 euros in these shares, the implicit transaction costs are 27.15 euros higher on Tradegate, 17.42 euros on L&S Exchange and 26.85 euros on gettex.

The average spread on the shares of PostNL, Galapagos, Vopak, Alfen, Fagron, Vastned, Heijmans, Acomo, Fastned and Brunel on 31-10-2022, measured at the same moment per share. Source: websites trading venues and Bloomberg

Lack of transparency
In addition to the higher spreads that are immediately observable, an investor trading on the three PFOF venues must also take into account that a larger transaction can be executed at increasingly unfavorable prices. There is no transparency in the depth of the order book; for an order that exceeds the immediately available volume, the market maker can basically set any price for the rest of the shares. Especially with market orders, this is a risk.

Trading too much is never wise, but especially not when spreads are high. These spreads always chop off a bit of your investment. Those who invest a large amount in one go to save transaction costs also face a very uncertain execution price on the alternative venues. Therefore, an investor should think twice before deciding to trade through one of these neo-brokers.

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