Zero Commissions – When Free Really Isn’t

There has been much in the financial news lately about the brokerage industry reducing commissions or even offering no commission trading and investing. While this seems like a great change, it isn’t without a catch. Brokerages exist to make a profit. They offer many fee-based services, but if they suddenly reduced all the fees to zero they would either go out of business or must earn money elsewhere.

 

Effects of Restructuring Commission Pricing

This is not the first commission or pricing structure change to the industry. In the late 1990’s, Small Order Execution System (SOES), allowed individual traders to access the markets and even decide what prices they wanted for stocks. This enabled them to buy and sell stocks at a better price than what the brokers were offering. As a result, both the spreads and commissions dramatically reduced.

If you are not aware, the spread of a stock is the difference between the price you can easily buy the stock, known as the Ask or Offer, and the price at which you can sell, the Bid. The retail buying price is always higher than the retail selling price. This is an additional opportunity for the brokerage to make money from its clients. Before SOES, spreads could easily be a dollar or more per share. When day traders began frontrunning the institutions using SOES, the spreads narrowed to a penny or two per share.

 

The Real Cost of Zero Commission Trades

Robinhood Financial was one of the major new disruptors to the brokerage industry.  They came into the markets promising fast executions of orders without the costs of commissions. On face value, this seems like an excellent opportunity as many traders would love to only pay an extra penny or two per share and forgo the commissions they used to pay. The problem is that they are really sacrificing much more.

Last month, FINRA fined Robinhood for failing to guaranty best prices for their customer’s orders. The regulatory body found that instead of routing the customer orders to the best source for the best price, they were favoring four market makers that were paying Robinhood for routing their customer orders to them.

 

Payment for Order Flow

This practice is called payment for order flow. It has been in place for decades and its existence is well known to exist to the regulatory bodies.  It is not illegal as long at the proper effort is made to ensure the best price is offered to the customer at the moment of processing the order. That statement alone exposes a few issues. What is the moment of process and what is the best price?

We first need to understand the mechanics of placing an order. Most retail investors incorrectly believe that when they hit their buy or sell button, their order is directly routed to the markets. This isn’t true. In effect, you sending your order online is like sending a text message to your broker for the shares you wish to buy or sell. The broker can decide where to route your order, either to the markets, to a regional exchange, to a preferred market-maker or even fill the order themselves internally. They can do as they wish as long as they give you the National Best Bid/Offer at the time your order is filled. Proving they did that is extremely difficult and many brokerages try to sell the orders for a profit or do not do their due diligence to get best pricing, as was the case with Robinhood.

 

Price Improvement

The other issue is price improvement. When you place a limit order to buy or sell, you are stipulating that you will only accept up to a certain price. However, there are times that the broker could get a better price than what you asked for. They should pass that savings on to you as price improvement. But a broker that does not charge commissions will instead turn the stock over to you at your requested price and keep the difference for themselves. While this may not seem like a lot, over the course of many trades and years, the difference can really add up!

So, what can a trader do to avoid this and still participate actively in the stock markets? There are alternative brokerages called Direct Access Trading (DAT) brokerages. These DAT brokerages utilize Electronic Communication Networks (ECN) to route your order to the exchanges directly or get price improvement through opposing orders on the ECN’s books. The execution of your orders is typically faster and you avoid manipulation or delay with your pricing. However, you will usually have to pay a small commission for the service, either less than a penny per share or a flat fee.

There are plenty of DAT brokers that one can choose from and we utilize them in our courses at Online Trading Academy to demonstrate the ease, speed and price advantage of them to our students. To learn more about the better methods of routing your orders and how to potentially improve your rates of return in the markets, attend our free 3-hour introductory class today!