Brokerage commission: Meaning, Criticisms & Real-World Uses

What Is Brokerage Commission?

A brokerage commission is a fee charged by a broker or brokerage firm to a client for facilitating a financial transaction, such as buying or selling securities. These fees are a primary component of trading costs within the broader category of investment fees and costs. The commission compensates the broker for their services in executing trades on behalf of an investor in the financial markets.

History and Origin

For nearly two centuries, brokerage commissions on stock trades in the United States were fixed, meaning all brokers charged the same rate for the same transaction. This system was maintained by the New York Stock Exchange (NYSE) and other exchanges. However, increasing pressure from regulators and a desire for greater competition led to a pivotal moment in the industry. On May 1, 1975, often referred to as "May Day," the Securities and Exchange Commission (SEC) enacted Rule 19b-3, which formally abolished fixed commission rates, allowing brokers to negotiate fees with their clients.⁸ This deregulation transformed the brokerage industry, leading to the emergence of discount brokers who offered lower commissions compared to traditional full-service brokers. The shift ultimately paved the way for the "zero commission" environment prevalent today.

Key Takeaways

A brokerage commission is a fee paid to a broker for executing trades.
Historically, these commissions were fixed but were deregulated in 1975.
The rise of discount brokers and online trading platforms led to a significant reduction in brokerage fees.
Many brokers now offer commission-free trading for stocks and Exchange-Traded Funds (ETFs), shifting their revenue models.

Interpreting the Brokerage Commission

A brokerage commission directly impacts an investor's net return on an investment. Higher commissions reduce the profit from a winning trade and amplify the loss from a losing one. For frequent traders or those executing small transactions, even a seemingly small commission can significantly erode returns over time. The interpretation of a brokerage commission has evolved significantly with the advent of commission-free trading, where the cost is seemingly zero. However, even in a "zero commission" environment, investors should understand that brokerages still generate revenue, often through other mechanisms, such as payment for order flow or interest on uninvested cash. Therefore, understanding the total cost of trading remains crucial for effective investment strategy and evaluating a broker's overall value proposition.

Hypothetical Example

Consider an investor who wants to buy shares of Company XYZ.

Traditional Commission Model: Suppose a broker charges a flat $9.99 brokerage commission per trade. If the investor buys 100 shares of Company XYZ at $50 per share, the total cost of the shares is (100 \text{ shares} \times $50/\text{share} = $5,000). Adding the commission, the total outlay is ($5,000 + $9.99 = $5,009.99). When the investor sells the shares, another $9.99 commission would apply, further impacting the net profit or loss.
Zero Commission Model: If the same investor uses a zero-commission broker, the upfront brokerage commission for buying the 100 shares at $50 would be $0. The total outlay for the shares would simply be $5,000. While seemingly free, the broker may still earn revenue from other sources related to facilitating the trade, such as payment for order flow.

Practical Applications

Brokerage commissions are a core aspect of financial transactions, particularly in equity, options, and bond markets. While explicit per-trade commissions have largely disappeared for online stock and ETF trading among many retail brokers, they still apply in various contexts, such as:

Mutual Funds: Some mutual funds, especially those with sales loads, may involve commissions paid to financial advisors or distributors.
Options and Futures: Trading derivatives like options and futures often incurs per-contract commissions.
Bonds: While often traded on a net price basis (where the broker's compensation is built into the price), some bond transactions may have explicit commissions.
Advisory Services: Brokers providing financial advice typically charge asset-under-management (AUM) fees or flat fees, rather than per-trade commissions.

The shift to "zero commission" trading has fundamentally altered the broker-dealer business model, particularly for retail investors. Large brokerage firms, including Charles Schwab, Fidelity, TD Ameritrade, and E*TRADE, eliminated online trading commissions for stocks and ETFs in late 2019, following the lead of newer platforms like Robinhood.⁷ This move has stimulated increased trading frequency and allowed investors to build more diversified portfolios with smaller trade sizes without incurring significant transaction costs.⁶

Limitations and Criticisms

Despite the appeal of "zero" brokerage commissions, the practice faces scrutiny regarding how brokers generate revenue and potential conflicts of interest. Without direct commissions, brokers often rely on alternative revenue streams, most notably payment for order flow (PFOF). PFOF involves a market maker paying a broker for the right to execute their customers' trades.⁵ This practice has led to concerns from regulators, including the SEC, who scrutinize whether brokers are truly fulfilling their best execution obligations—the duty to obtain the most favorable terms for customer orders—when receiving compensation for routing order flow.

Th⁴e Financial Industry Regulatory Authority (FINRA) Rule 5310 requires brokers to use "reasonable diligence" to ascertain the best market and execute trades at the most favorable possible price under prevailing market conditions, considering factors like price, speed, and likelihood of execution. Cri³tics argue that PFOF creates an incentive for brokers to route orders to market makers who pay the most, rather than necessarily those offering the absolute best price or liquidity for the customer. The SEC has actively explored reforms to market structure to address these potential conflicts and enhance transparency for retail traders. Whi²le execution quality metrics have generally improved, the debate around the potential impact of PFOF on the effective cost of trades for retail investors continues.

Brokerage Commission vs. Payment for Order Flow (PFOF)

While both brokerage commissions and payment for order flow (PFOF) represent compensation for brokers, they differ in their mechanism and transparency to the investor.

A brokerage commission is a direct, explicit fee charged by a broker to a client for executing a trade. It is typically a fixed amount per trade, a percentage of the trade value, or a per-share/per-contract fee. The investor sees this cost directly deducted from their account.

Payment for Order Flow (PFOF), on the other hand, is an indirect form of compensation. Instead of charging the client a commission, the broker receives a rebate or payment from a third-party market maker (or exchange) for directing customer orders to them for execution. The market maker profits from the bid-ask spread and shares a portion of that profit with the broker for the order flow. For the individual investor, the PFOF itself is not a direct charge on their statement, making it less visible. However, critics argue that PFOF can create a conflict of interest, potentially influencing a broker's order routing decisions away from the absolute best execution in favor of a higher payment.

FAQs

Are brokerage commissions still common today?

For typical online stock and ETF trades, most major retail brokers in the U.S. now offer "zero commission" trading. However, commissions may still apply to other financial products, such as options, futures, mutual funds with loads, or certain bond transactions.

How do "zero commission" brokers make money?

Zero commission brokers primarily generate revenue through other means, such as payment for order flow (PFOF), interest income on uninvested cash balances in customer accounts, premium services, and securities lending.

What is "best execution" and how does it relate to commissions?

"Best execution" is a regulatory requirement that obligates brokers to obtain the most favorable terms reasonably available for their customers' orders. Even with zero brokerage commission, brokers are still legally bound to seek best execution. This means they must consider factors like price, speed, and likelihood of execution, regardless of any payment for order flow they might receive.

##¹# Do all investment products have brokerage commissions?
No. While many investment products historically involved brokerage commissions, the landscape has changed significantly. For example, direct investments in certain bonds or mutual funds might not have a separate brokerage commission but could have other fees or a built-in spread. Many online brokers offer commission-free trading for stocks and ETFs.