Updated: Jul 7, 2021
In the last several years, zero commission stock trades have become more and more popular. In turn, investing in the stock market has become easier and cheaper than ever before. There are many different apps and platforms that have made it very simple for a new investor to get involved.
Companies like Robinhood have been utilizing this kind of promotion, and with the ease of use of their mobile app, have brought many more younger investors into the market. That's not a bad thing, but in light of a recent SEC ruling against Robinhood (and a fine of $65 million) we thought it was worth explaining how a zero commission fee isn't exactly "free."
Payment for order flow
Payment for order flow (PFOF) is when a third-party firm (usually a larger market maker like Citadel Securities) pays a broker like Robinhood a small fee for orders to be routed through them. Market makers like Citadel make their money on the spread -- the difference between the bid and asking price on a stock. Thus, it will pay a broker like Robinhood to route trading volume to itself so it can make money, and Robinhood earns a fee for directing traffic to a market maker. Ultimately, where does that revenue come from? In short, the investor.
Basically, an investor pays a higher price per share when buying, and receives a lower price per share when selling shares of a company. The difference is kept by the market maker, which then gives some of that back to the broker-dealer (like Robinhood) for placing order volume through them.
Nothing is for free
While "commission free" sounds great, it's important to remember it isn't exactly free. To be fair, the price difference is very small. When compared to the old $4.95 a trade that used to be advertised (and which is still an incredible value), it is certainly cheaper. And if an investor makes a buy for the long haul, a few pennies or a few bucks for a trade is not going to make or break an investment decision. However, "commission free" is deceiving and might be referred to as a "hidden fee." At least under the old model it was more transparent. You knew what you were paying.
In the recent SEC ruling referred to above, this "hidden fee" reportedly cost investors $34.1 million in inferior trade pricing after taking into account paying zero commission.
There is a reason why apps like Robinhood's exist. They make money. In the second quarter of 2020, Robinhood nearly doubled their PFOF revenue from the first quarter, making $180 million.
It's not all bad
Like mentioned earlier, apps that have simplified the process of investing have brought a new generation of investors. Getting people to save and put their money to work is a good thing.
If someone is just starting their investing journey, though, it's also good to know how you are paying someone to handle your money -- and what you're getting for the cost. The process should be fully transparent. Make sure to research and compare. For example, it might cost a little more to make trades somewhere else, but the extra data and information available to make informed decisions could be worth the cost.
If investing is something you want to get started in, we would love to help. Check out our philosophy on modern investing, and feel free to contact us for assistance.