Is There a Catch to Free Stock Trading?

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Is There a Catch to Free Stock Trading?

Most brokers now provide free stock trading to investors. But how do brokerages generate money if commissions are waived? A thorough dive into the commission-free trading movement finds a plethora of business operations that generate profits, often at the expense of customers. As a consequence, bigger consumers and regular traders may wish to pay for premium accounts.

Key Takeaways

  • Robinhood was the first company to provide commission-free trading, and they generated money via interest, margin lending, fees for improved services, rehypothecation, and payment for order flow.
  • The majority of other brokerages now provide commission-free trading, and their income from payments for order flow increased dramatically in 2020.
  • Brokerages’ use of payments for order flow to generate money from commission-free transactions may result in worse quality order execution, resulting in slightly higher purchase prices and marginally lower sell prices.
  • When rehypothecation is utilized to support commission-free transactions, it might raise risk during times of financial hardship.

Robinhood

Robinhood was the first to provide commission-free trading, with both cash and margin accounts. The broker-dealer used to promote that it generated money by generating interest on customer monies that were not invested.

However, when near-zero interest rates returned in 2020, that method became significantly less advantageous. Other profit streams identified in disclosure forms included margin lending, monthly fees for improved services, and rehypothecation. Rehypothecation enabled the corporation to utilize customer securities to fund other financial transactions.

In a margin account, rehypothecation happens when the broker-dealer utilizes an asset—in this example, stock securities—as collateral to meet their own commitments or interests. In other words, they may use your stocks as collateral to support their own market wagers or borrow money from a bank. This technique works well in calm situations. When the financial system is under stress, on the other hand, it might have terrible repercussions.

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New Robinhood clients are automatically assigned to margin accounts, putting them at risk of rehypothecation. Customers may, however, actively downgrade them to cash accounts.

Robinhood also offers several more traditional methods to earn money. For example, the higher-tier Robinhood Gold costs a monthly subscription, which adds another source of profit. They also offer charge schedules for all services other than buying and selling stocks, such as wire transfers and overnight domestic check delivery. You’ll also have to pay for hardcopy statements, account transfers to another brokerage, and phone-assisted transactions.

Payment for Order Flow

Payment for order flow is one of the key ways brokerages profit from commission-free trading. Payments for order flow may result in worse order execution, resulting in slightly higher purchase and marginally lower sell prices. This is not unique to Robinhood, and it was an increasing source of income for brokerages in 2020. TD Ameritrade, for example, got $526.59 million in order flow payments in the second quarter of 2020.

During the second quarter of 2020, Robinhood earned $271.2 million in compensation for order flow. They assured customers that they were receiving the best attainable execution price. However, Robinhood gives little information about how such orders are packaged. As a consequence, the SEC accused Robinhood with breaking federal securities laws in December 2020, including a lack of transparency on how the firm collected money and a failure to execute transactions in the best interests of the customer. The SEC ordered Robinhood to pay a civil penalty of $65 million.

Regulation NMS of the Securities and Exchange Commission (SEC) requires Robinhood to provide consumers with the National Best Bid and Offer (NBBO).Given the company’s terms and circumstances, that promise may be more difficult to deliver than it seems.

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Even minor delays in completing market orders might provide self-serving opportunities to reduce quality and increase revenues for the brokerage. They have few frills and have regular customer service complaints, which is to be anticipated given the ultrathin margins, which create a natural conflict of interest between consumer wants and the company’s profits. Nonetheless, they have consistently added features in recent years and have maintained their huge appeal. Many of these services come at a cost that reduces profitability, such as Robinhood Gold, which has monthly fees.

Mainstream brokerages, such as Charles Schwab and E*Trade, also provide commission-free trading and have profited significantly from paying for order volume. Customers of all of these brokerages must ultimately determine if it is worthwhile to pay for better order execution.

Wealthy consumers who trade often may find that a premium account with better order processing saves them more money than commission-free trading.

The Bottom Line

In only a few years, commission-free stock trading went from a market niche occupied by Robinhood to a mainstream feature. Simultaneously, the addition of premium and fee-based services made Robinhood increasingly similar to other brokers. High-volume traders, on the other hand, must exercise caution when it comes to transaction execution price and quality.

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