The Four Hidden Costs Of Zero-Commission Stock Brokers

Not long ago, investing in stocks seemed to be reserved only for the elite few. Aside from the depth of knowledge required for such a lucrative financial market, investing in equities wasn't cheap.

Arguably, it wasn't until 2013 when an American financial service brand named after an English folklore archer legend pioneered the concept of commission-free stock trading.

Robinhood's mission was to 'democratise finance for all' by allowing even cash-strapped investors an opportunity to invest like everyone else.

Soon enough, we began witnessing already established service providers like Charles Schwab, E-Trade, Interactive Brokers, and TD Ameritrade following the same route.

Traders using fixed-dollar commission services also started to migrate some or most of their capital to brands like Robinhood. Over time, experts have begun questioning whether so-called commission-free brokerages are really free.

While these entities provide immense benefits, they have also come under fire for questionable business practices. Many have begun wondering precisely how such businesses make money.

So, what are the four hidden costs of using zero-commission stock brokers?

#1: The bid/ask spread

Spreads are present in all financial markets yet may be less obvious to most customers. The spread is the difference between an instrument's bid and ask price. In other words, it's the mark-up placed on every trader's order by the broker who sources the stock’s liquidity from a market maker.

Essentially, most commission-free brokerage services will widen the spread to cover their costs. This means customers pay a bit more for each position than they might with traditional firms.

Of course, the charging of spreads is entirely legal and is the primary compensation method most brokers use in other securities. The point is that a spread is typically never considered a commission and doesn't reflect as such on a trader's account.

However, it notably impacts the price a trader ultimately receives after execution, especially for smaller-cap or less liquid stocks.

#2: Foreign exchange conversion fees

Such fees don't just apply to currency brokers but stock brokers as well. Nonetheless, conversion fees can easily be overlooked by most. This occurs when the currency of the traded stock differs from the account’s denomination.

Many platforms will allow their clients to trade foreign-listed stocks that will likely have a different currency than their home country. The charge comes into play when traders sell these shares where the broker has to convert them to their home currency, to which they typically apply anywhere from 2% to 4% as a fee.

#3: Payment for order flow

This is the most controversial method of how zero-commission brokers derive most of their profits.

Payment for order flow (PFOF) is the compensation a stock broker accepts from a market maker for sending their clients' orders to them. Market makers pay brokers a rebate from the instrument's spread, as much as a penny per share, for this privilege.

In the old days, orders from brokers were routed to established stock exchanges like the New York Stock Exchange until market makers came along. Naturally, PFOF is one of the main ways commission-free trading happens since there is less red tape dealing with a market maker than an exchange.

However, the most considerable criticism of PFOF is the perception of brokers not providing their customers with the best execution, leading to a conflict of interest. A broker might be incentivised to give the worst price if they receive the highest payment for order flow.

This practice is now controversial, leading to it being banned in countries such as Canada and the United Kingdom. So, although clients aren't directly charged for this operation, it affects the execution, which itself will have a cost impact down the line.

#4: The perceived gamification of stock trading

While all the previous costs have been somewhat literal, this section deals with something that is not as explicit but still significant. The perceived gamification of stock trading encourages many to treat stocks more like a game by engaging in impulsive trading.

Thanks to the convenience of mobile app technology, many commission-free brokers have perfected their marketing to get more people trading. In 2021, Robinhood was one of the prominent brokerages criticised for this perception.

Aside from common push notifications, the provider used emojis and digital confetti on its platform, which was eventually removed. Everyone has the freedom to decide when to trade, and people are becoming more educated on the risks of trading.

Yet, if someone is unaware of the other mentioned costs, they can easily slip into something like day trading, which not everybody can master.

Curtain thoughts

Commission-free brokerages have lowered entry barriers and levelled the playing field. The point of this piece is to highlight some subtle and not-so-subtle ways such services may cost their customers. As they say, there is no such thing as a free lunch.

*This piece was originally published on Medium.