No-fee brokers seem great at the outset. But how do brokers make money? And is it coming out of your pocket?
Robinhood was the darling of the investing world for a while. Its app was the easiest way for young people to invest and there were no commissions. It’s gone through a lot over the past few years, starting with a $65 million fine from the SEC for its payment for order flow practices.
Today, most brokers have either extremely low or no commissions. And they still use the practices that led to Robinhood’s massive fine. What is it? And does it matter to you? Let’s go over Payment For Order Flow (PFOF).
How have so many brokerage firms eliminated fees?
Historically, brokers made money with commissions and the same nickel and diming (we’re going to have to start calling that quarter and dollaring soon) fees you see at a bank. Robinhood started the trend of low and no fees by selling its order flow to market makers.
Market makers work for big financial institutions and add liquidity to the market. When you sell a stock at the market price in your brokerage account, while the market is open, it typically closes immediately. That probably doesn’t mean there is a real buyer out there; there’s likely a market maker buying the stock from you and then quickly turning around and selling it to someone else.
Market makers make money from the bid/ask spread. When you buy or sell a stock, you don’t actually use the current stock price. You pay the ask price and get the bid price. The market maker pays the bid and gets the ask.
Let’s say you want to buy a stock with a current price of $10 per share, a bid price of $9.99, and an ask of $10.01. You end up paying $10.01 to the market maker who just bought it for $9.99. That’s a profit of just two cents per share for the market maker. The only way they make money is by going through a ton of transactions. That’s where Robinhood comes in.
The market maker pays Robinhood for its order flow and gets that nice bid/ask spread on every single Robinhood order. The market maker not only gets to secure a consistent cash flow stream, but they can widen the spread a little.
Traditional brokers kept bid/ask spreads down, but Robinhood makes less money that way. The SEC found that Robinhood customers lost $34.1 million from 2015 to 2018 because of bad bid/ask prices. And that accounts for $0 commissions.
3 ways brokerage firms make money
Commissions are the old-fashioned way for brokers to make money. Decades ago, brokers were full service, and you could only place trades via phone. At that point, most brokers charged a percent of the trade as commission.
Discount brokers like Charles Schwab came onto the scene in the 1990s and charged flat commissions around $25-$30 per trade. By the mid-2000s, commissions were driven down to around $5 per trade by competition.
Brokers also make a commission on mutual funds with front-end loads. If you buy a mutual fund, make sure there isn’t a front-end load attached. You’re probably better off focusing on index funds with low fees.
Some brokers also have annual account fees. You can typically get around these by keeping your balance below a certain level or not using financial advisory services.
Full-service brokers will also charge withdrawal fees, inactivity fees, deposit fees, and any other fee they can sneak onto a statement. Like commissions, fees are slowly being phased out.
Payment for order flow
Brokers can generate revenue by selling order flow to market makers. Payment for order flow allows the market maker to secure a revenue stream and the broker to do transactions without charging commissions or other fees.
Why payment for order flow is controversial
There’s two parts to this. The obvious part is the $34.1 million or more dollars lost by Robinhood customers to bad trade prices. But the second part is the deceptive marketing practices. According to the SEC, Robinhood repeatedly misled customers with incorrect statements and outright omissions in its marketing material and customer communications.
A customer that understood how Robinhood was making money may have kept using the platform for convenience, but they also may have paid a small commission for each trade to secure a better price.
Should you care whether your platform uses PFOF?
The answer is, it probably doesn’t matter. While $34.1 million seems like a big number, in reality, it’s a drop in the bucket for each individual Robinhood user. It’s unlikely anyone using Robinhood had a material loss because of PFOF. And Robinhood probably doesn’t tolerate the same level of bid/ask spread widening it once did now that the SEC is watching it.
If you have a good long-term focus on investing and diversification, neither the bid/ask spread nor a commission will have much effect on your results after years or even decades. However, it’s good to know where your money is going, so you can always compare your trade prices to what Yahoo! Finance says the bid/ask is at the time of the trade.