About 100 years ago Edwin Lefèvre wrote Reminiscences of a Stock Operator, in which he tells a fictional autobiographical tale of his adventures, explorations, successes, and catastrophes at trading in the stock markets of post-Gilded Age, capitalistic America. He started his trading adventures in what were called bucket shops, gambling joints that sold short-term bets on stock price fluctuations. No shares were actually traded. You put down a dollar, and settled in to watch the parade of prices coming in across the ticker. If the stock you picked went up a dollar or two, then you could cash in for a small profit. If your stock dropped a dollar, you were wiped out and the bet was over. Bucket shops catered to the small “investor”, never enjoyed a good reputation, and were partially blamed for several severe market declines in the 1900s. By the 1920s they were outlawed in the U.S.
Though bucket shops are barely remembered, the customer-broker dynamics that were most prominently on display still exist in various forms today. By taking on the role of neutral arbiter and being on the other side of the trade, the proprietor had an incentive to stack things against his customers. There were many tricks, including some that involved manipulation of the actual stock market in order to “paint the tape” with prices that would wipe out customers’ tickets. If you want to know more, I suggest getting a copy of the aforementioned book.
Some of these practices are still watched against by the SEC. Painting the tape is still illegal, as is colluding to move prices specifically to make money by deluding investors into thinking that news exists when it does not. Nevertheless, there are practices you should be looking for that either aren’t illegal or which are very difficult for the SEC to catch.
The nature of the problem starts with the activities of the broker. Theoretically, they act on your behalf, going into the market and securing the requested transaction at the best price available. The problems begin when this model stops being accurate.
For example, your broker may take the trade on its own books in one form or another, effectively acting as the counter party to your trade. Even if the transaction is executed at posted market prices, your ability to detect the “current market price” is restricted by the fact that there is no single central clearing market anymore. The broker may be paid to direct your order to specific exchanges, where the price you obtain there is not as good on another exchange. The broker may own part of that exchange, or vice versa, so that even if the entities are legally separate, both still have incentives.
In the “old days” when retail customers still paid commissions, brokers may have had less reason to collude with dealers who pay them for order flow. Retail customers who are unhappy with the execution of their trades then wouldn’t trade, reducing the broker’s commission cash flow. Now that nearly all the leading retail brokerages charge zero or nearly zero commission, how they make their money gets a little more squirrelly.
Even if your broker is not a bucket shop, it becomes a useful and illuminating exercise to actively keep in your mind the hypothesis that they are a bucket shop, and ask yourself whether the behavior that you see corresponds to that of a bucket shop. Small things like efficiency of execution, timeliness, and price improvement will speak to the integrity of your broker. If their app or web interface has glitches, if they fail to acknowledge orders or fail to deliver reports, you would be justified in asking yourself to what degree they are using bucket shop-like tactics to either increase their own revenue or that of their clearing agents.
Last week Robinhood’s behavior was clearly over this line. They cited capitalization requirements at first, but the restrictions on order placement indicated that other interests were also being kept in mind.
Punishing a brokerage for this behavior can be expensive, because moving an account has some costs in time, effort, and logistics. Nevertheless, since the SEC is unlikely to be able to act in these situations, you need to be prepared to prosecute the matter yourself. That means being alert to the signs and letting the broker know that you know about anomalous behavior that you consider outside the lines.
