(Disclosure: Some of the links below may be affiliate links)
These last few years, we have seen more and more commission-free brokers pop up. At first sight, they look great. Who would not want to pay fewer transaction fees?
But usually, if something is too good to be true, that is because it is! How do these commission-free brokers make money if they do not charge anything?
We discuss that exact question in this article! By the end of this article, you will know how these brokers make money and whether that is good for you!
Over the last decade, many commission-free brokers have entered the market. Even some big names in the industry have started offering commission-free trading on their platform.
You have probably heard of Robinhood. This broker has become very popular since it started in 2015. Robinhood was not the first of the commission-free brokers, but it probably made the most noise. And probably the one with the most controversy.
With the rise of Robinhood, many new commission-free brokers have been trying to get some of the profits.
But there are also some much larger brokers like Charles Schwab that offer commission-free trading. Even Interactive Brokers started offering commission-free trading in the United States with IBKR Lite. But IBKR Lite only represents 3% of Interactive Brokers’ profit, so that is not a huge profit maker.
But if these companies do not charge fees, how can they make money? In 2021, Robinhood had 1.8 billion dollars in revenue. Where does it come from?
We find out how commission-free brokers can make money without charging commissions.
1. Payments For Order Flow (PFOF)
Many commission-free brokers’ primary revenue source is from payments for order flow.
Instead of going through a stock exchange, the broker sells the orders from its clients to a market maker. And this market maker will then execute the order in place of the broker, generally on the public stock exchange.
The market maker generally profits from the spread between the price the client pays and the price the market maker can execute it. The client pays A, but the market maker will generally buy it at a better price, B. And the difference between B and A is the profit for the market maker.
This profit is why the market maker is willing to buy retail orders from commission-free brokers to profit from the price.
In theory, everybody is happy:
- The investor did not pay any commission
- The broker got paid for selling the order flow
- The market maker made a profit on the transaction
In practice, this does not always turn out that way.
First, we look at the legality of this practice. In the United States, this is allowed by the Securities and Exchange Commission (SEC). However, these payments are still regulated. Indeed, the broker must ensure that the client gets the best price. So, they should only sell the order to the market maker at the best price.
In practice, this is not always what the broker is doing. The broker’s interest is to sell to the market maker that pays more, not to the market maker that makes the best trade. We see that there is a significant conflict of interest here! The broker’s interest and the investor’s interest are different.
In 2020, Robinhood was fined 65 million dollars by the SEC for not giving the best price to its customers. For millions of transactions, customers got bad prices, while Robinhood got paid a lot by market makers for its orders.
It is also illegal in many countries in the world. For instance, it is illegal in Canada, the United Kingdom, and several European countries.
In 2022, the SEC announced they considered banning payments for order flow. The SEC banning PFOF would mean the end of many commission-free brokers.
The selling of orders is one of the most significant issues with commission-free trading. I prefer a good price on my order rather than not paying any fees. A bad price can cost you more than fees on medium orders.
And the conflict of interest between the broker and the investor is a big red flag for me. This shows that if it sounds too good to be true, that is because it is!
Critics may argue that, in theory, the customer could get a better price by going through a payment for order flow than if the broker was executing the order itself. And this is true, but only in theory. In practice, I do not think many commission-free brokers (if any) will provide a better price than a good broker executing it on the exchange.
Commission-free trading makes it too easy to trade. Investing in stocks is a great thing. But day trading stocks without any proper research is just plain dumb. And these brokers encourage their users to trade as much as they can. Indeed, they make more profit if their users make more trades. And users should not make more trades. They should make more intelligent trades.
2. Margin Loans
Another way commission-free brokers can make money is on a margin loan.
A margin loan is when you get a loan from your broker with your stocks as collateral. Margin loans are a widespread way of getting a loan to invest money.
Commission-free brokers often offer margin loans. And the interest rate on these loans is not free. Again, in theory, this is all good and fine. I have no problems with brokers making money.
But in practice, the margin loans offered by commission-free brokers are much more expensive than those provided by better brokers.
For instance, at the time of this writing (16.07.2022), we can compare the margin loan rates of two brokers:
- Robinhood: 4.25% on USD
- Interactive Brokers Pro: 3.08% on USD
The loan from Robinhood is 1.17% more than the one from IBKR. This loan is more than 35% more expensive. On any loan, this will make a significant difference. More than what users could save on fees!
If you are not using margin loans, this should not make a significant difference. However, many investors on commission-free brokers use margin loans without really learning about them (another problem!). And they lose much more on their margin loan than their saved fees!
If you ever want to use margin loans to invest with leverage, I recommend you avoid commission-free brokers.
3. Interest on cash
The third way commission-free brokers can make money on their investors is to get the interest on their cash balance.
There has generally always been positive interest on USD cash balances. But most commission-free brokers would not give that interest back to the investors. Instead, they would use it to cover their expenses.
Sometimes, they would only give part of the interest to their users.
This is not a huge deal since most people hold little cash on their broker accounts. Nevertheless, this is s still a hidden fee.
4. Lending stocks
Many cheap brokers will lend your stocks out to other investors.
When an investor is selling short, he is selling a stock he does not have. So, he is borrowing a stock, selling it, and hoping he can buy later cheaper. When borrowing some shares, there is an interest rate to be paid. This interest rate is a way for the lender to make money.
In most cases, a cheap or commission-free broker will lend out its investors’ shares without sharing the profit. For instance, by default, DEGIRO will sell its investors’ shares and keep the profits.
These loans present a slight risk for the investor and a lack of profit. If the investors were to lend shares themselves, he could keep at least some of the profits.
For instance, with Interactive Brokers, you can lend out your shares and get 50% of the profit. And you can choose whether you want this feature or not. By default, IB will not lend your shares.
As you can see, there are many ways for a commission-free broker to make money. However, in the end, all these ways can be detrimental to the investors.
I will repeat it: If it sounds too good to be true, it is because it is! You should not fall for the trap of commission-free trading.
A commission-free broker could have your best interest in a perfect world. However, in most cases, a conflict of interest exists between a commission-free broker and its customers. Indeed, there is a reason why the best brokers are not free: offering a good brokerage service is not free.
Therefore, I prefer a good, non-free broker to a commission-free broker. That way, I get better execution prices, some interest on my cash, good margin loans should I need them, and a better trust that my money and information are properly handled.
If you are looking for a great broker with outstanding fees, I recommend Interactive Brokers. You can read my Interactive Brokers Review for more information.
Many people ask me why I use Interactive Brokers instead of one commission-free broker. With this article, you will hopefully understand exactly!
I am not saying that all non-commission-free brokers are great. There are also some very bad brokers out there. On the other hand, I do not know any good commission-free broker.
What about you? What do you think about these commission-free brokers and how they profit from investors?
Download this e-book and optimize your finances and save money by using the best financial services available in Switzerland!Download The FREE e-book
- More articles about Best Brokers
- More articles about Investing
- How to buy an ETF from IBKR Mobile
- Yuh Review 2024: One app to pay, save and invest
- How to Open an Interactive Brokers Account in 2024?