Not so long ago, investing in stocks seemed to be something reserved only for the elite few. Aside from the depth of knowledge required for such a lucrative financial market, investing in equities wasn’t cheap because of commissions and other fees.
It wasn’t until some time from 2013 when an American financial service brand named after an English folklore archer legend pioneered the concept of commission-free stock trading.
Robinhood has a mission of ‘democratizing finance for all’ by allowing even cash-strapped investors an opportunity to invest like everyone else. Soon enough, we began witnessing established service providers like Charles Schwab, E-Trade, Interactive Brokers, and TD Ameritrade following the same route as Robinhood.
Traders who were using fixed-dollar commission services also started to migrate some or most of their capital to brands like Robinhood. As time has gone on, many experts have begun questioning whether so-called commission-free brokerages are really free.
While such entities provide immense benefits, they have also come under fire recently for some questionable business practices. Many have begun wondering precisely how these businesses make money.
So, what are the four hidden costs of using most zero-commission stockbrokers? Let’s find out.
#1: The bid/ask spread
Spreads are present in all financial markets yet may be less obvious to most customers than they should. The spread is the difference between the bid and the ask price of an instrument.
In simple terms, it’s the mark-up placed on every trader’s order by the broker who sources the liquidity of a share from a market maker. Essentially, most commission-free brokerage services will widen the spread to cover up their costs.
This means customers pay a bit more for each position than they might with traditional firms. Of course, the charging of spreads is entirely legal and is the primary compensation method used by most brokers in other financial securities.
The point is a spread is typically never considered a commission and typically doesn’t reflect as such on a trader’s account. However, it has a notable impact on the price a trader ultimately receives after execution, especially for smaller-cap or less liquid stocks.
#2: Foreign exchange conversion fees
Such fees apply to currency brokers and stockbrokers. Nonetheless, conversion fees can easily be overlooked by most. This occurs when the currency of the traded stock is different from the one their account is denominated.
Many platforms will allow their clients to trade foreign-listed stocks that will likely have a different currency than their home country. The charge comes into play when traders sell these shares where the broker has to convert them to their home currency, to which they typically apply anywhere from 2% to 4% as a fee.
#3: Payment for order flow
Perhaps the most controversial method of how zero-commission brokers make money is through a practice known as ‘payment for order flow.’ Most research suggests this approach is where nearly all so-called commission-free brokerages derive most of their profits.
Payment for order flow (PFOF) is the compensation a stockbroker accepts from a market maker for sending their clients’ orders to them. For this privilege, market makers pay brokers a rebate from the instrument’s spread, as much as a penny per share.
In the old days, orders from brokers were routed to established stock exchanges like the NYSE (New York Stock Exchange) until market makers came along. Naturally, PFOF is one of the main ways commission-free trading happens as there is less red tape dealing with a market maker than with an exchange.
However, the biggest criticism of PFOF is the perception of brokers not providing their customers with the best execution, leading to a conflict of interest. A broker might be incentivized to intentionally give the worst price if they receive the highest payment for order flow.
This practice is now controversial, leading to its ban in countries like Canada and the United Kingdom. So, although clients aren’t directly charged for this operation, it affects the execution, which itself will have a cost impact down the line.
#4: The perceived gamification of stock trading
While all the previous costs have been somewhat literal, this section deals with something that is not as explicit but is a major factor nonetheless. In a nutshell, the perceived gamification of stock trading encourages many to treat stocks more like a game by engaging in impulsive trading behavior.
Thanks to mobile app technology, many commission-free brokers have perfected their marketing in an effort to get more people to trade because of smartphone convenience. In 2021, Robinhood was one of the main brokerages criticized for this perception.
Aside from common push notifications, the provider used emojis and digital confetti on their platform, which it has now removed. Everyone has the freedom of deciding when to trade, and people are becoming more educated on the risks involved with trading.
Yet, if someone is not aware of the other mentioned costs (especially if they are naturally inexperienced), they can easily slip into something like day trading. The higher the frequency becomes, the less money one is likely to make in the long run.
As briefly mentioned, commission-free brokerages have lowered the barrier to entry and leveled the playing field. The point of this article is to highlight some subtle and not so subtle ways such services do cost their customers in the present moment and the long run, which present new challenges.
As they say, there is no such thing as a free lunch, which is precisely the case with zero-commission stock brokers.