The concept of commission-free trading has been around for a few years now, prompting many investors to ask how brokersmake their money. If they are charging no commission, where do they get their income and is this to the detriment of clients?
Initially, many day traders felt a natural pull towards commission-free trading. It made sense to trade as often as you like with no commission. However, if only things were as simple as that!
How did early commission-free trading work?
This concept revolves around extremely high volumes and an array of additional income streams. While everything was in the client agreement, many day traders were unaware of the exact nature of this type of trading. Some of the issues to be aware of include:-
Payment for order flow
We now know that many companies offering commission-free trading created significant revenue streams from what is called "payment for order flows". This saw brokerages using a specific market maker to carry out their client orders in exchange for a relatively small payment per transaction. However, many suspect this arrangement was to the detriment of investors, often resulting in slightly higher purchase prices or slightly lower selling prices.
Upgraded services
Many of the brokerages offering free trading also had a range of upgraded services for which they would charge customers. While relatively small charges would seem irrelevant at the time, due to the considerable volume of transactions going through each day, these figures also added up. This created yet another income stream.
Interest
When interest rates were at “traditional” levels, there was also an opportunity to make a turn by placing client funds on deposit overnight. This was and continues to be a legitimate activity, where accumulated funds would attract a higher interest rate than individual deposits. Due to the trickle-down effect, those with relatively small deposits would receive relatively low interest. Brokers could take a turn on the interest received and paid to customers.
Margin lending
We also know that some broker-dealers used client collateralto fulfil their stock obligations in the past. This is known as rehypothecation and tends to work relatively well in quiet times but can lead to significant trading losses in volatile markets. This practice has been outlawed, with client funds and assets now ring fenced from broker assets.
Modern-day commission-free trading
While the rules and regulations regarding commission-free trading have changed in recent times, some brokers still offer this service. However, many investors are now looking back toward commission based trading and a greater level of transparency.
What does commission-based trading have to offer?
We have seen a significant tightening of regulations, more protection for clients, and greater transparency in recent times. When comparing and contrasting commission-free trading against commission-based trading, there are numerous benefits for those that pay commission upfront:-
Best market price
The idea of payment for order flow is alien to those brokers who work on a commission basis and offer best execution at all times. Paying slightly more for a stock than the market price or receiving marginally less when selling is a recipe for disaster for day traders. Many day traders deal on relatively small margins; therefore, dealing outside of the best market price does not make sense.
Transparency is the key
Here at GIS UK Ltd, we prefer to be upfront and transparent about all aspects of our business and trading procedures.Whether dealing directly with the market or via our trading helpdesk, the whole process is clear and documented, from start to finish. Transparency breeds confidence and trust, which are all critical elements of the client-broker relationship.
Reinvestment in new technology
Over the years, we have continued to reinvest in new technology, trading platforms and customer services. Striving to continually improve our offering has increased trading volumes and business income, which funds future reinvestment. In addition, the ability to share efficiency and cost savings means that we can maintain highly competitive dealing charges while still providing a first-class service.