In 2014, Robinhood disrupted the financial technology industry, pioneering the idea of commission-free trading.  Soon many brokerages, including eToro, Schwab, TD Ameritrade, Degiro, and TradeStation, started following the trend.

By the time the COVID-19 pandemic hit, online brokers have rushed to promote their commission-free trading deals with adverts popping up everywhere which begs the question – how do brokerages profit if they’re waiving commissions?

In its first quarter of 2022, the well-known broker, Degiro, reported its strongest quarter in the company’s history, with revenues increasing 14.2% from its previous quarter to €118.1 million.

In addition, the company’s profits rose 79.5% from €27.9 million in the 2021 fourth quarter to €51.7 million.

A deeper dive into the commission-free trading movement reveals that though this may look good on paper, free trading may cause bad trading behavior and businesses building profits elsewhere, sometimes to the client’s disadvantage.

It also indicates that brokers almost certainly recoup the costs in other, less transparent ways.

What to look out for when opening a zero-commission account

A larger source of revenue for commission-free brokers is “order flow.”

PFOF or payments for order flow is the compensation or fractions of a share that a brokerage firm receives for directing orders for trade execution to a particular market maker.

An investor expects to receive the best price available when placing a trade with a broker.  However, the broker may go directly to the exchange (e.g. the Nasdaq) where the security is traded or use an intermediary trading company to get the most favorable pricing for trade execution.

The trader will (or will not) soon discover that some of their free trades could cost them substantially more if they’re not getting the best price at the time when the order is executed.

Also worth noting is that, in many cases, commissions won’t entirely drop to zero.  Some brokers still charge commissions for options trades and services like broker-assisted and phone-initiated trades, which could lead to a net positive for them.

“I don’t see all of these firms writing off that revenue and not monetizing on any of the trading processes,” says President of Wescott Financial, Grant Rawdin.  He added, “The mole could come up another hole.  Our challenge is to find out where their revenues come from.”

Consensus

For the retail investor, the problem with PFOF is that their brokerage might be routing orders to a particular market maker solely for its own benefit and not the investor’s.

Moreover, Commission-free brokers tend to attract uneducated traders with minimal or no experience and often don’t know how to plan or execute trades properly.  Be careful not to fall into this trap since most traders will count their losses.

Though commission-free brokers may be adequate for some, IRA accounts (Individual Retirement Account) with mainstream brokers who provide full fee transparency may be a better alternative.

“I’m not a fan of the hidden ways custodians make money.  I think this will accelerate the focus on transparency of fees for service in the industry.” – President of Wealth Consulting Partners, Gavin Spitzer.