Skip to main content

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 

Comments

Popular posts from this blog

Sound Advice: July 8, 2020

Jobs Are Up, But So Are New Infections Through the spring months, m ost of the economic data was extremely negative, with record declines in employment and consumer spending.  The speed of that decline had no modern precedent. We are now in a recession.   The shortest recession on record occurred in 1980 and lasted just six months.  Second place goes to a seven-month recession in 1918-19, which was tied to the Spanish flu pandemic.  The big question is: When will this recession end? Given surprisingly strong data in May, April may have been the bottom of this economic cycle.  If so, it will have been the shortest recession on record.  With massive support from the Federal Reserve, the federal government, and the reopening of previously closed businesses, employment surged unexpectedly.  At the same time, pent-up demand, stimulus checks, and generous unemployment benefits led to a reacceleration of commercial activity. Still, not all is rosy.   In his recent testimo

Sound Advice: May 17, 2023

Say hello to PEG No, she’s not a new neighbor.   PEG is the acronym for Price-to-Earnings Growth Ratio.   Although stock analysts tend to litter their conversations with shop talk such as PE (Price-Earnings Ratio), ROI (Return on Investment), and Debt-to-Equity Ratio, PEG may well be more telling about the level of stock valuations. The process of evaluating stocks begins with evaluations of the underlying companies.   This includes income statements (a.k.a., profit and loss statements) and balance sheets. Concerns about income statements focus on the trends in earnings, which include profit margins, tax rates, and net income.   What’s important here are the trends over time.   Are margins rising or at least holding their own? Are tax rates following a consistent pattern or have there been interim aberrations? And is the bottom line expanding? Flat or rising margins are good.   Level tax rates are also OK, but if there’s been an outlier, what would have been the impact on net i

Sound Advice: April 13, 2022

Tough Time For Bonds Over the years, difficult periods for the stock market have invariably prompted “flights to quality” on the part of investors.   In most cases, these shifts meant that funds were being moved from higher risk holdings to those appearing to offer increased safety.   That usually led to a redeployment from stocks to bonds, typically those of the U.S. Treasury or high-grade corporate borrowings.   With interest rates now rising, however, that approach is no longer working.  Indeed, in recent months it has backfired.  In the latest calendar quarter, the Treasury market posted its worst performance in more than 40 years.  For the period, the ICE 15+Year U.S. Treasury Index sustained a loss of 13%.  The iShares 20+ Year Treasury Bond Index dropped 14%. This is typical of what takes place when interest rates are rising.  The rule of thumb for bonds is that when rates rise, bond prices fall.  In most cases, the longer the maturity of the bonds, the greater the interim