In recent news brokers such as Robinhood have been making headlines with their online trading app and more importantly their pioneering of commission-free trading. Many other online brokers, DeGiro, eToro, Ameritrade and Schwab, to name a few, followed suit!
But as the saying goes “There’s no such thing as a free lunch!”. Think about it logically, these companies do not open trading accounts for the good of their health they do so for the good of their balance sheets.
So, what is the catch…. Hidden costs! Hidden costs make trading more expensive and less transparent. What are those hidden costs? Where are they making their money? While it is not obvious at first what these costs are, there are many such as Interest, margin lending, fees for upgraded services, fees for all services not related to buying or selling stock, rehypothecation and most importantly order flow. Let’s take a look at each of these.
Interest: Many brokers made money by earning interest on the uninvested portion of client funds. However, the return of near zero interest rates has made that strategy less profitable.
Margin Lending Fees: Margin is money borrowed from a broker to purchase stocks. A margin account is a standard trading account in which a trader is allowed to use the current cash or securities/assets in the account as collateral for a loan. The broker charges interest on the amount of margin used in an account. Different stocks have different margin rates of interest – the more volatile the stock the higher the margin interest rate. The broker can increase the margin interest rate at will. If you buy a stock on margin and it starts to devalue very often the broker will increase the margin required to hold this stock. Leverage conferred by margin will amplify both gains and losses and more importantly in the event of a loss, a margin call may require liquidating positions without prior consent in order to cover the loan. Margin Interest is calculated in a variety of different ways, depending on several factors.
Upgraded Services: Platforms offered on a zero-commission basis are often very basic; what trades qualify for zero commissions is it just stocks, what about Options, ETF’s or Crypto Currencies; delayed prices on stocks and/or options prices; limited number of trading tools, e.g. charts, technical analysis, order types; limited access to news and research. Upgrading to a more dynamic platform will incur a fee.
Non-Trading Fees: Zero commissions mean you will pay for EVERYTHING else, for all services not directly related to buying or selling stocks – Wire transfers, paper statements, support both online and telephone.
Rehypothecation: This is often overlooked, in fact most people have never heard the term, let alone understand the practise. Rehypothecation is where brokers use, for their own purposes, assets that their clients have used as collateral with them. The broker uses the rights to that collateral to participate in their own transactions with the obvious goal of financial gain. It was a very common practice until 10 years ago.
Order Flow: This is by far the most important factor to consider when opening a trading account. Order flow is the primary way that brokers make money from commission-free trades. What is Order Flow? This is the payment a broker receives for routing trades for execution. Brokers route orders to specific exchanges, this in turn can result in delayed trade executions. Even small delays in executing market orders can adversely impact your trading account often leading to a less favourable trade execution price. You may not get the best price for your trade in other words you may pay a few pennies more on the buy and get a few pennies less on your sell, particularly if there is a widespread between the bid and the ask. This applies to Stocks, Options, EFT’s, Crypto Currencies, and all other financial instruments. In Europe order flow is illegal however the European based brokers like DeGiro and eToro make up for this with wider spreads also known as slippage.
Order flow can generate self-serving opportunities for the broker which will impact the quality of service you receive and at the same time builds profits for the broker. In the 2nd quarter of 2020 alone Robinhood made $180 million from order flow payments and Ameritrade made $325 million. They are making more money using order flow than they did with traditional trading commissions. Order flow is big business!
There is more and more being written on the reality of commission free trading and the hidden costs involved, Forbes, The Investors Chronicle, The Financial Times and many others are advising caution against using brokers with such offerings. Trading is an investment, and like all investments it can be profitable or financially crippling. The bottom line is that zero commission trading has evolved from niche brokers such as Robinhood in to mainstream brokers in the last couple of years. However, it is advisable to approach such offers with extreme caution Zero Commissions does NOT equal Free Trading!
If you have any other questions about commission free trading or anything else please don’t hesitate to contact us!