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Sound Advice: November 23, 2022

How do brokers make money with zero commissions on trades?

That’s a question many investors are asking.  If stock trades are free, one may well assume that there’s something fishy . . . and there is, though there is an ongoing controversy about whether any rules are being broken.

The key phrase is payment for order flow (PFOF), which is what brokerage firms receive for directing trades to a particular market maker for execution.  These payments are typically fractions of a penny per share, but they add up to substantial sums when cumulated by the volume of trades taking place.

The Golden Rule for trading is best execution, which means that brokers are required to get the lowest prices when buying and highest prices for selling on behalf of its clients.  As long as this rule is followed, no lines are crossed, but when brokers direct trades to market makers who may be specializing in certain stocks, it becomes a gray area, especially when the trades are done at other than the best prices.

When questioned about executions, brokers tend to rely on claims of the better liquidity provided by these firms.  The more problematic situations are those that involve smaller brokerage firms, which may have difficulty handling large trades.  The flip side of PFOF is the increased cost to clients as a result of inferior execution.

This practice led to agency intervention in late 2020, when the SEC fined Robinhood Markets $65 million for failing to properly disclose to customers PFOF payments it received for trades that did not result in best execution.  Trading in meme stocks seems to have been an area where these kinds of abuses have taken place.

Although zero commissions are now widespread, it should come as no surprise that offsetting revenues from things such as PFOF have increased considerably to reduce the shortfall.  A recent study by Piper Sandler, a NY-based investment bank, showed PFOF revenues from equity trading of major brokerage houses up from 27% to 122% from the first quarter to the second quarter of 2020.

Payment for order flow isn’t the only tool being used to fill the gap.  Other revenue sources include interest, margin lending, and fees for new or updated services.  One way or another these companies will find ways to keep their profits flowing, especially when they appear to be executing trades at no cost.

Free lunch?  Not exactly, but in most cases clean enough to pass the test.

N. Russell Wayne, CFPÒ

www.soundasset.com

Any questions?  Please contact me at nrwayne@soundasset.com 

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