Is There a Catch to Free Stock Trading?

Investing

Investors can now trade stocks for free through most brokers. But how do brokerages make money if they’re waiving commissions? A deep dive into the commission-free trading movement reveals various business activities that build profits, sometimes to the disadvantage of clients. As a result, larger customers and frequent traders might want to consider paying for premium accounts.

Key Takeaways

  • Robinhood pioneered commission-free trading, and they made money from interest, margin lending, fees for upgraded services, rehypothecation, and payment for order flow.
  • Most other brokerages now offer commission-free trading, and their revenues from payments for order flow rose rapidly during 2020.
  • The payments for order flow used by brokerages to make money from commission-free trades may result in lower quality order execution, leading to slightly higher buy prices and marginally lower sell prices.
  • When rehypothecation is used to fund commission-free trades, it can increase risk during periods of stress in the financial system.

Robinhood

Robinhood pioneered commission-free trading, offering both cash and margin accounts. The broker-dealer used to advertise that it made money by earning interest on the uninvested portion of client funds. However, the return of near-zero interest rates in 2020 made that strategy far less profitable. Disclosure documents revealed other profit sources, including margin lending, monthly fees for upgraded services, and rehypothecation. Rehypothecation allowed the company to use client securities to support other financial activities.

Rehypothecation occurs in a margin account when the broker-dealer uses an asset—stock securities in this case—as collateral to fulfill their own obligations or interests. In other words, they can fund their own market bets or borrow money from a bank, using your stocks as collateral if things go haywire. This practice tends to work well in quiet times. On the other hand, it can have disastrous consequences when the financial system is under stress.

Robinhood’s new customers default to margin accounts, potentially exposing them to rehypothecation. However, customers can manually downgrade them to cash accounts. Margin interest is waived on the standard account.

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Robinhood also has some more conventional ways to make money. For example, the higher-tier Robinhood Gold charges a monthly fee, adding another profit source. Furthermore, they have fee schedules for all services not directly related to buying or selling stocks, such as wire transfers and overnight domestic check delivery. You’ll also pay for paper statements, transferring the account to another brokerage, and telephone assisted trades.

Payment for Order Flow

Payment for order flow is a primary way that brokerages make money from commission-free trades. Payments for order flow may result in lower quality order execution, leading to slightly higher buy prices and marginally lower sell prices. This practice is by no means limited to Robinhood, and it was a growing source of revenue for brokerages in 2020. For example, TD Ameritrade received $324 million in payments for order flow in the second quarter of 2020, up 60% from the first quarter.

Robinhood itself made $180 million from payments for order flow during the second quarter of 2020. That’s an increase of 98% over the first quarter. They tell clients they’re getting the best available execution price. However, Robinhood provides little detail on how they package those orders.

Robinhood is bound by Securities and Exchange Commission (SEC) Regulation NMS, which requires customers to receive the National Best Bid and Offer (NBBO). That promise may be harder to fulfill than it sounds, given the company’s terms and conditions. Even small delays in executing market orders can generate self-serving opportunities to adversely impact quality and build profits for the brokerage. They offer few frills and attract frequent customer service complaints, which are expected because ultrathin margins generate a natural conflict of interest between customer needs and the company’s profitability. Even so, they’ve added features regularly in the last few years and have retained their enormous popularity. Many of these features come with price tags that add to profitability, including Robinhood Gold, which incurs monthly fees.

Mainstream brokerages, including Charles Schwab and E*Trade, now offer commission-free trading as well. They also make substantial amounts from payment for order flow. However, their payments for order flow are growing more slowly than at Robinhood. Ultimately, customers of all of these brokerages must decide whether it is worth paying for better order execution.

Wealthy customers who trade frequently might save more with a premium account offering superior order execution than they do with commission-free trading.

The Bottom Line

Commission-free stock trading evolved from a market niche dominated by Robinhood to a mainstream feature in just a few years. At the same time, adding premium and fee-based features made Robinhood more like the other brokers. However, high-volume traders still need to be careful about trade execution price and quality.

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