Why “free” trading isn't free

“If there are no costs for a product you use, then you are not the customer - You are the product.”

‍

What is “free” trading? 

Free trading or “commission-free” trading, means there’s no charge for users or investors when buying or selling a stock or ETF. By making investment accessible, free trading has seen a massive rise (unsurprisingly) in popularity amongst frequent traders. When it comes to trading commissions... zero is the new normal.

Robinhood, the Silicon Valley startup, is usually considered the pioneer of commission-free trading. In 2019, its zero commission model prompted a pricing war with incumbent brokerages who fought back by cutting commissions to $0.

With sizable retail trading firms like ETrade, TD Ameritrade and Charles Schwab jumping on the bandwagon, it has become an industry-standard amongst stock traders, allowing investors to open free accounts and avoid fees on trades, commission and brokerages. 

But if you think the concept of “free” trading is too good to be true, then you are probably right. “Free” trading platforms make money in various ways, which often means investors feel like it’s free, when the reality is quite different. 

‍

‍How do free trading providers make money? 

Free trading apps and platforms usually have diversified product offerings for a broad range of users and investors. We have listed some of the primary revenue streams used by free trading platforms below:

‍

Rehypothecation

Rehypothecation is a practice whereby companies leverage client securities as collateral for supporting their financial activities. For example, this occurs in a margin account when the broker-dealer uses your stock securities as collateral to fulfil their obligations or interests. After the collapse of the Lehman Brothers in 2007, brokers became wary of rehypothecation.

‍

Payment for order flow (PFOF)

According to the SEC (The Securities and Exchange Commission), payment for order flow is “...a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”  

Retail brokers send client orders to market makers, which in turn, commit to provide the retail brokers liquidity at the current national best offer (when the investor is buying)
or national best bid (when the retail investor is selling) —or better. However, payments for order flow may result in lower quality order execution, leading to higher buy prices and marginally lower sell prices.

Neobrokers such as Robinhood are paid for the right to execute customer orders by market makers, who profit from the knowledge of the order flow. The brokers are also paid a small commission on the routed trades, which ends up racking billions from customer trades. According to Forbes, more than 75% of Robinhood’s revenue over the last five quarters came from PFOF, “...reaching $720m in 2020 and $341m in Q1 2021 alone”.

Payment For Order Flow has been banned in the UK since 2012 as the FCA concluded that it undermined transparency and efficiency when it came to price execution. It was also deemed a conflict of interest for brokers, who would rather deal with market-makers than provide their best effort to their clients.

There are UK-based firms that use infrastructure platforms based in the USA that benefit from PFOF, whilst not financially benefiting from the practice. While this practice isn’t contrary to FCA rules, it’s often obfuscated from the “free” trading platform’s users.

‍

Bid-Ask Spread

Another common way that “free” or commission-free trading is paid for is with widening spreads, which in effect merely move the fees, transferring the cost from commissions to spreads.

Bid-Ask spread is calculated as the difference between the highest price a buyer is willing to shell out for an asset and the lowest price that a seller will accept. Thus, an individual looking to sell will receive the ‘bid’ price, while one looking to buy will pay the ‘ask’ price.

Brokers such as Etoro have in the past been criticised for offering “commission-free” trading, but often widening spreads, forcing users to pay more when buying a stock and sell at a lower price.

‍

Currency Exchange Fees

‍
Another source of income for “free” trading brokerages comes from currency conversion. Companies like Freetrade in the UK charge currency conversion fees for every trade made in a different currency other than British Pounds. The fee is equivalent to around 0.45% plus the spot exchange rate that the firm’s forex exchange partner charges, per order.

Similarly, Bulgaria-based Trading 212 uses contracts for difference (CFD) to let users trade stocks, FOREX, etc., without commission. But it added a fee of 0.15% for stock and ETF trading in a different currency to that of the account holder.

‍

Other Premium features 

‍Companies like Robinhood have other sources of profit, including monthly fees for upgraded services. For example, customers can participate in margin trading with Robinhood Gold, which starts at $5 per month. This allows you to borrow money from Robinhood so that you’re trading more than just your own money — it gives you extra buying power and the potential for more significant returns and losses.

According to The New York Times, in 2017, Schwab added premium service for those with at least $25,000 in assets, which includes help from a human certified financial planner: That now costs $30 a month, plus a one-time initial $300 fee, along with the costs of investments. And it also requires a high cash component.

‍

Risks of free trading

Although the emergence of zero-commission trading is generally a win for investors, there are many potential downsides, including:

1) investors paying for “free” trading in the form of lower returns on the capital invested (bid-ask spread)

2) the temptation to over-trade. It could be more tempting to move in and out of stock positions more frequently because it doesn’t cost anything

3) sale of customer’s order flow data by brokers

4) gamification of investing, usually risky for inexperienced investors

5) less transparency in costs

Free stock trading may offer good opportunities for investors, but they also mask various profit models and have the potential to hurt long term returns. In addition, brokers often pursue less transparent ways to earn commissions, leaving investors to pay more.