What Is Broker Commissions?
Broker commissions are fees charged by a brokerage firm or a financial professional for executing transactions on behalf of a client. These charges are a primary component of investment costs and fees within the financial industry. Historically, broker commissions were a significant expense for investors, directly impacting the profitability of their trades. While the structure and prevalence of these commissions have evolved significantly, they represent the compensation received by a broker-dealer for facilitating the buying and selling of securities such as equity shares, bonds, mutual funds, or Exchange-Traded Funds.
History and Origin
For nearly two centuries, the United States financial markets operated under a system of fixed commission rates, mandated by exchanges. This meant that all brokerage firms charged the same fee for a given transaction, regardless of the trade size or the client. The fixed commission structure often made trading prohibitively expensive for individual investors, favoring large institutional investors.24, 25, 26
A pivotal moment in the history of broker commissions occurred on May 1, 1975, a date widely known as "May Day." On this day, the Securities and Exchange Commission (SEC) abolished fixed commission rates, ushering in an era of negotiated commissions. This deregulation aimed to increase competition among brokers and reduce trading costs for investors.22, 23 The change paved the way for the rise of discount brokers, who offered lower commission rates but typically provided less investment advice. Charles Schwab, for instance, capitalized on this shift, establishing his firm to offer discounted trades, which led to a significant reduction in costs for retail investors and fundamentally reshaped the brokerage industry.20, 21 This competitive pressure eventually led to many firms, including major players, moving towards zero-commission trading for many types of securities, a trend that accelerated in 2019 when Reuters reported in 2019 that leading brokerages like Charles Schwab, TD Ameritrade, and E*TRADE eliminated commissions on U.S. stocks and ETFs.19
Key Takeaways
- Broker commissions are fees paid to a brokerage firm for executing securities transactions.
- Historically, fixed commission rates made trading expensive until the SEC's "May Day" deregulation in 1975.
- The rise of discount brokers and technological advancements, including online trading and electronic communication networks, have driven down broker commissions significantly, with many firms now offering zero-commission trading for stocks and ETFs.
- While explicit trading commissions have decreased, investors may still encounter other fees, such as those for options trades, margin account use, or advisory services.
- Understanding broker commissions is crucial for managing overall investment costs and evaluating the value proposition of brokerage services.
Interpreting Broker Commissions
Understanding broker commissions involves recognizing their impact on net returns and the different ways firms structure their compensation. For investors, lower broker commissions translate directly into higher net gains on successful trades and reduced losses on unsuccessful ones. The interpretation of these fees has shifted from a direct transaction cost to a more nuanced consideration of the overall value provided by a brokerage firm. Full-service brokers, for example, might still charge higher commissions or incorporate fees for bundled services like research, personalized advice, and advanced trading tools. In contrast, discount brokers and online platforms, which dominate the current landscape, often offer zero commissions for basic stock and ETF trades, relying on other revenue streams such as payment for order flow, interest on uninvested cash, or fees for premium services like trading on a margin account. Therefore, when evaluating a brokerage, an investor considers not just the stated broker commissions but the comprehensive fee schedule and the range of services offered.
Hypothetical Example
Consider an investor, Sarah, who wants to buy 100 shares of Company XYZ, trading at $50 per share.
Scenario 1: Fixed Commission Era (Pre-1975)
In the era of fixed commissions, Sarah might have paid a non-negotiable fee, for example, $75, regardless of the trade size.
- Cost of shares:
- Broker commission:
- Total cost:
Scenario 2: Discount Brokerage Era (Post-1975, Pre-Zero Commissions)
Later, with discount brokers, Sarah might have paid a flat fee per trade, say $9.95.
- Cost of shares:
- Broker commission:
- Total cost:
Scenario 3: Zero-Commission Era (Current)
Today, with many online brokers offering zero broker commissions on stock trades, Sarah might pay no direct fee for the execution.
- Cost of shares:
- Broker commission:
- Total cost:
This hypothetical example illustrates the dramatic reduction in the direct cost of trade execution for individual investors over time, largely driven by changes in broker commission structures.
Practical Applications
Broker commissions primarily manifest in investment accounts, directly influencing an investor's net returns. In the modern financial landscape, while direct broker commissions for basic stock and Exchange-Traded Funds (ETF) trades have largely disappeared at many major online brokerages, these fees still exist for other types of transactions and services. For instance, options trading typically involves a per-contract fee in addition to, or in lieu of, a base commission. Similarly, trading foreign stocks, large block transactions requiring special handling, or certain mutual funds may still incur broker commissions.18
From a regulatory standpoint, the Securities and Exchange Commission (SEC) has implemented measures to ensure transparency and fairness regarding how financial professionals charge clients. The Securities and Exchange Commission's Regulation Best Interest (Reg BI), for example, requires broker-dealers to act in the best interest of a retail investor when making recommendations of any securities transaction or investment strategy involving securities. This includes requirements related to disclosing and mitigating conflicts of interest arising from compensation, such as broker commissions.16, 17 Firms are obligated to provide clients with a clear understanding of all fees and costs associated with their accounts and transactions.13, 14, 15
Limitations and Criticisms
Despite the widespread shift to zero direct broker commissions for many trades, certain limitations and criticisms persist within the brokerage compensation model. One significant concern relates to potential conflicts of interest, particularly when a financial professional or firm is compensated through commissions. Such compensation structures can create an incentive to recommend transactions that generate higher commissions for the broker, even if those recommendations are not necessarily in the client's best interest.10, 11, 12 This potential misalignment of interests has been a long-standing point of contention in the industry. The SEC and Financial Industry Regulatory Authority (FINRA) have emphasized the importance of identifying and mitigating these conflicts, even with the implementation of standards like Regulation Best Interest.8, 9
Furthermore, while explicit trading commissions have decreased, brokerages often generate revenue through other, less transparent means. These can include payment for order flow, where brokers receive compensation from market makers for directing client orders to them; interest income on cash balances in client accounts; or fees for ancillary services. Some critics argue that these alternative revenue streams can still indirectly influence the quality of trade execution or lead to less favorable pricing for clients, even without direct broker commissions. Academic research has explored how institutional clients' trading patterns are influenced by brokerage commissions, suggesting that higher commissions might sometimes reflect payments for premium services rather than just basic execution.5, 6, 7 This highlights the complexity in fully assessing the total cost of trading beyond the stated commission rates.
Broker Commissions vs. Investment Advisory Fees
The distinction between broker commissions and investment advisory fees is fundamental to understanding how financial professionals are compensated and the nature of the services they provide. Broker commissions are typically transaction-based, meaning a fee is charged each time a client buys or sells a security through a broker-dealer. This compensation model is associated with a "suitability" standard, where the broker is required to ensure that a recommended investment is suitable for the client's profile at the time of the recommendation.
In contrast, investment advisers generally charge an ongoing fee, often calculated as a percentage of the client's assets under management (AUM). This fee structure is associated with a "fiduciary" standard, which legally obligates the investment adviser to act in the client's best interest at all times. While a broker-dealer primarily facilitates transactions, an investment adviser provides continuous advice, portfolio management, and financial planning. Some firms are "dually registered" as both broker-dealers and investment advisers, meaning they can offer both commission-based brokerage services and fee-based advisory services. It is crucial for investors to understand the capacity in which a financial professional is acting and how they are compensated, as this impacts the standard of care owed to the client and potential conflicts of interest.1, 2, 3, 4
FAQs
What are broker commissions?
Broker commissions are fees charged by brokerage firms or brokers for facilitating the buying and selling of securities on behalf of clients. They are a form of compensation for the trade execution service provided.
Are broker commissions still common today?
For most common trades like U.S. stocks and Exchange-Traded Funds (ETFs) on major online platforms, direct broker commissions have largely been eliminated. However, commissions may still apply to certain types of transactions, such as options contracts, mutual funds that carry a sales load, or foreign securities.
How do brokerages make money if they don't charge commissions?
Brokerage firms that offer zero-commission trading often generate revenue through other means. These can include payment for order flow (receiving rebates from market makers for directing trades to them), interest earned on clients' uninvested cash balances, fees for margin account loans, or charges for premium services and products like robo-advisory services or actively managed portfolios.
How do broker commissions affect my investment returns?
Broker commissions are a direct cost of investing. Even small fees can compound over time and reduce your overall investment returns. For example, if you make frequent trades, high broker commissions can significantly erode your profits. This is why many retail investors prefer platforms with low or zero commissions.
What is "May Day" in the context of broker commissions?
"May Day" refers to May 1, 1975, when the Securities and Exchange Commission (SEC) abolished fixed commission rates in the U.S. stock market. This deregulation led to increased competition among brokerage firms, the rise of discount brokers, and a substantial reduction in trading costs for investors.