When Robinhood launched its mobile app with zero-commission stock trading in December 2013, the demand was so high, there was a waiting list to join.

Today, the company is practically a household name. Some other so-called “fintech” startups have joined them, chief among them SoFi, the student-loan refinancer out of San Francisco.

But when it was just startups offering zero commission, it was easy to ignore. At first, these were small companies, without an established customer base, and with apps that appealed mostly to younger people.

But last Tuesday, on October 1, the field got a lot more crowded. That’s when broker giant Charles Schwab Corp. (SCHW) announced that starting the following Monday, October 7, it would charge zero commission on all domestic stock and ETF trades.

Schwab has 12 million customers and manages $3.7 trillion in assets, so the company’s October 1 announcement shook the financial industry.

Almost immediately, competitors TD Ameritrade Holding Corp. (AMTD), E*Trade Financial Corp. (ETFC), Ally Financial Inc. (ALLY), StockTwits, and Tradestation announced they too were removing commissions. Smaller online broker Interactive Brokers Group Inc. (IBKR) had announced their zero-commission service the week before.

Meanwhile, stocks of these brokers took a tumble, with Schwab falling more than 12% just over that trading day:

Now, for us traders, paying less in commission is always good. But as is often the case in life, there is no free lunch. What the brokers lose on commissions, they’ll make up in other ways.

So before you leave your old broker to jump headfirst into a zero-commission offering, here’s what you need to know…

Commissions – A Brief History

Decades ago, brokers such as Schwab did a lot of work to get your stock trades executed. They had to run an office where you could go see your broker, that broker had to be able to send messages to their floor trader on the stock exchange, and that trader had to be good at cutting deals with other floor traders.

That was a lot of manpower, office space, messengers, and phone lines to pay for. High commissions made sense to cover those costs.

But as time has passed, this process has become more and more automated. You could eventually call your broker instead of visiting in person. And now, of course, trade execution is only a mouse click away.

That progression gave us a rough history of brokerage commissions charges that looks like this: The NYSE held commissions in a fixed price structure and allowed no discounting from its founding in 1792 until the mid-1970s when discounted commissions were first allowed (or more appropriately mandated, by the Securities and Exchange Commission). This brought about reduced commissions that were immediately available including the now famous $29.95 of Charles Schwab. This was a reduction of around 75 percent versus the old fixed commission rates of the time. Interestingly, that 1975 commission of $29.95 would be an inflation adjusted $142 in 2019!

Continued deregulation of the brokerage industry in the mid-to-late 1990s led to the boom in online brokerages where competition has lowered commission prices again by 90% or more when compared to the “old” discount standard of $29.95 (though Schwab was defending that price point into the early 2000s). Commissions as low as 0.5 cents per share have been commonplace and were the standard until Robinhood came along…

And now the mainstream brokerage world has joined ranks. But don’t let that fool you. Zero-commission trades can come with a number of hidden costs.

Some brokers, such as Interactive Brokers and TradeStation, have only removed commissions from their “lite” offerings, which lack some features other customers get. TradesStation’s TSgo service, for example, eliminates commissions but also removes access to the downloadable trading platform that allows you to statistically backtest your trading strategy.

This platform is what made the broker so successful in the first place. Instead, TSgo customers will be restricted to a web-based trading platform with far fewer features.

Similarly, Interactive Brokers’ IBKR Lite may have no commissions, but also does not include access to the powerful research tools that made the broker so popular with traders.

Schwab, meanwhile, will still charge a $25 fee for placing a trade through an actual broker, and $5 for doing it through their telephone service.

In other words, expect the service, tools, and research available via zero-commission offerings to be less useful than otherwise.

But there are two more, hidden costs to using a zero-commission broker. These especially affect frequent traders…

The New Breed of FinTech

Robinhood has been offering zero-commission trades successfully for six years now. And unlike some other startups, like Uber for example, they don’t do so simply by burning through their investors’ money.

Instead, they do what’s called “selling order flow.” This technical-sounding name is actually a pretty simple process. Let’s say you place an order with your broker to buy one share of Apple Inc. (AAPL) at market price.

Now, your broker could execute your trade itself, probably bundled with all its other customers who want to buy AAPL at the same time. Or, it could work with another party, like a market maker or stock exchange that needs to balance its books, or a large fund trying to sell its AAPL holdings.

Competition between different parties trying to fill your order will generally result in the best possible price for you.

But to make money, Robinhood has been doing something slightly different. Instead of looking for someone that will get you your trade of AAPL at the best price for you, they have been “selling” your order to the highest bidder. In other words, they have another party execute your order for you in return for that party paying Robinhood.

So instead of your order being executed by the institution that can give you the best price, brokers like Robinhood have your order being executed by the institution that can pay Robinhood the most.

The difference for your order to buy AAPL may be a penny or less per share. But over time, especially for frequent traders, those pennies add up to much more than you would have paid in commission.

On their commission-based platform, Interactive Brokers has long prided itself for making sure your trades were executed at the best possible price, no matter how much or little the market makers paid the broker.

But with its new, zero-commission IBRK Lite service, the broker has announced it will be recouping its costs by selling order flow.

Schwab, TD Ameritrade, and E*Trade also sell order flow.

This is all legal, and all these brokers disclose that they do this in their fine print. And in most cases, the cost to you will be minimal. But it can add up over time, and in some cases, when liquidity dries up or volatility spikes, having your trade executed by the wrong institution could cost you a lot.

But even that’s not all.

Because probably the most important way going zero-commission can cost you is by the broker not paying you what you would otherwise get.

Here’s what I mean…

Brokers vs Banks

Most brokers can, at first glance, look a little bit like banks. After all, before you start trading with them, you have to first open an account and put money in it. This account works a little bit like a checking account, except instead of using the money in it to buy your groceries, you use that money to trade.

But the key difference between brokerage accounts and bank accounts is most brokers won’t pay you any interest on the money sitting in your account.

And the few that do will do so only if your balance is large enough, and generally pay you a lower interest rate than a bank would.

But when they loan you money, or loan it to other banks, they charge the prevailing interest rate. Margin loans can even have a higher-than-normal interest rate.

The difference between the interest rate they pay you for your money and the interest they charge others is a huge source of income.

And expect that difference to get even larger as brokers settle into a zero-commission world.

Traders don’t necessarily let their money sit in their account doing nothing. But sometimes there just isn’t a trade to be made. Not to mention the hassle of constantly moving money back and forth between your bank accounts and your brokerage account.

Already, the low interest rate paid on these cash deposits is a major source of income for brokers. In 2018, for example, commissions were only 7% of Schwab’s net revenue – while 57% came from interest income.

Robinhood, meanwhile, just announced that it is moving from zero interest to 2.05% interest on its cash deposits.

So before you change brokers to one with zero-commission fees, think about what you need from a broker. More research, customer service, and tools, as well as better interest on deposits and better trade execution will always come at a price.

As for the stocks of these brokers, they will likely bounce back once the new model for how they’ll make money becomes clearer. As you saw, Schwab only made about 7% of their net revenue last year from commissions.

But for TD Ameritrade, commissions make up more than 30% of net revenue.
This will all take time to shake out. In the meantime, I suggest you stay away from these stocks – and read the fine print to see whether a zero-commission broker really would be cheaper for you.

I’ll follow-up in a future article with some details about the different styles of zero-commission accounts available. Until then…

Great Trading and God bless you,
D. R.

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