Commission-free trading has been popular for a while. Robinhood has launched this new business model by offering ‘no commission’ trading. Online brokerage firms that operate according to this model are called ‘low-cost’ brokerages. We can count Robinhood, E-trade, TD Ameritrade, and Webull among the companies that operate according to this model. Young customers especially appreciated this offer. However, there is criticism towards this business model, claiming they are harming users. I decided to research this subject more detail and share what I learned with you. Milton Friedman has an excellent quote that has stuck in my mind: “There is no free lunch.” This statement implies that every decision we make has an opportunity cost. Companies like Robinhood are not charities. Their aim is to make a profit. So how do they make money? What is the business model?
What’s the business model of commission-free trading?
There is a saying that if something is ‘free,’ you can probably be the product. In this case, this saying is also true. The business model of commission-free trading can be summarized as selling your payments of order flow to market makers at the wholesale level. I can roughly summarize the primary function of the brokerage house as matching the trading requests. Suppose you have entered a bid price for a stock at a specific price. Another set the minimum (ask/offer price) he was willing to sell for the same share. These orders are matched against each other in an exchange or brokerage house. But most of the time, there is a difference depending on the demand and supply for that share. This difference is called the bid-ask spread. If demand far exceeds supply, these prices rise gradually.
For example
Let me give a concrete example. Let’s say a buyer is willing to buy XYZ stock at the market price of $12.5. Let a seller be willing to sell his share of XYZ for $12.45. The spread is 5 cents per share. The market maker, who will execute these orders, pockets the difference. 🙂 In this way, if 1,000 shares change hands, the market maker’s profit from this transaction is 1,000 * 5 cents = 50 dollars. In real life, this difference varies from a few cents to 50-60 cents.
Is zero spread possible?
Can the purchase price and the selling price be exactly the same? The answer to this question is sometimes. Such markets are called locked markets. The same stock can be sold in different markets; however, there are delays in data transmission due to other computer systems in real life. Therefore, the buying and selling prices are sometimes not up to date. In such cases, the spread can be zero.
Who are the market makers?
A market maker is a person or firm that actively offers continuous buy and sell prices for assets traded in the market. Most of the time, the market maker is a brokerage firm. The market maker constantly announces how much he will change, that is, the trading volume. For the market to function correctly, it has to perform these tasks without interruption, even when the volatility is very high. The market maker pockets the bid-ask spread for the risk he takes. The stock exchange and regulatory bodies, to which the market maker is bound, determine which rules he will act.
How many market makers can there be?
Many exchanges have multiple market makers competing with each other. However, in some exchanges, the market maker may have a monopoly. For example, monopoly market makers on the New York Stock Exchange (NYSE) are specialized by asset groups. They are responsible for forming the best price and adequately executing the orders placed by the traders. Citadel, for example, is one of the world’s largest market makers. This firm handles one-third of the transactions regarding US stocks. According to Bloomberg Robinhood generated half its 2019 revenues from trading orders sold to Citadel and 2 Sigma.
What if Robinhood sells your payment flow orders?
Commission-free trading brokers sell the buy and sell orders from you to market makers by signing a ‘Payment for Order Flow‘ contract. So they don’t actually do the matching job. With this contract, market makers also give these companies a small portion of their income from the bid-ask spread. By small, in the second quarter of 2020, TD Ameritrade earned $324 million, Robinhood $180 million, E-trade $110 million, and Charles Schwab $66 million. “So what’s wrong with that?” you can say. Of course, the devil is in the details. 🙂
NBBO
The US Securities and Exchange Commission has obligated brokers to provide the best possible purchase price (lowest) and best selling price (highest) indiscriminately when trading on behalf of their clients. This rule is called the National Best Bid and Offer (NBBO). In fact, NBBO figures are calculated and distributed by Security Information Processors (SIPs). These systems are part of the National Market System Plan (NMSP). There are separate SIPs for the NYSE (and a few other exchanges) and the NASDAQ. NBBO data is constantly updated throughout the day. Traders perform transactions by looking at these prices. With this regulation, it has been tried to ensure that investors get the best prices.
Commission-free trading means
Brokers providing commission-free trading, on the other hand, do not guarantee such a best price. Looking at the contracts you signed, you can see that this guarantee is not given. So you pay a much wider spread and don’t even know how much you’re paying! In this context, the US Securities and Exchange Commission opened an investigation in 2020 because Robinhood advertisements were misleading. In the ads in question, it was said that the best offers were offered for free. However, an additional $34.1 million loss was incurred to the detriment of the customers, as the best prices were not used while executing the customers’ orders. At the end of the process, Robinhood settled by paying $65 million in damages. For the board’s decision, see here.
In conclusion
There is no free lunch. While commission-free trading sounds good, you pay the cost somehow. In fact, as we saw in the Robinhood example, your fee may be higher than the commission costs. Therefore, paying attention to this issue is helpful when choosing a brokerage firm. I hope this has been an enlightening article.