Brokerage commissions: Meaning, Criticisms & Real-World Uses

What Are Brokerage Commissions?

Brokerage commissions are fees charged by a broker-dealer to clients for executing transactions in financial securities. These fees are a primary component of investment fees and represent the cost incurred by an investor to buy or sell assets like equity shares, bonds, options, and mutual funds. While historically a significant direct cost, the landscape of brokerage commissions has evolved, with many firms now offering "commission-free" trading for certain asset classes. However, even in such cases, brokers may earn revenue through other means related to client trades.

History and Origin

For much of Wall Street's history, brokerage commissions were fixed, non-negotiable rates set by exchanges like the New York Stock Exchange (NYSE). This tradition, in place for 183 years, meant that all brokers charged the same commission for a given transaction size, regardless of the service provided or market conditions. This system began to face scrutiny in the late 1960s from regulators who believed that fixed rates hindered competition. Despite strong opposition from the brokerage industry, the Securities and Exchange Commission (SEC) formally adopted Rule 19b-3 on January 23, 1975, ending all fixed commission rates charged to non-member investors, effective May 1, 1975.⁹ This momentous day became known as "May Day" on Wall Street, a term popularized because it evoked distress for an industry that anticipated significant disruption.⁸ The shift to competitive, negotiated rates fundamentally transformed the securities industry, leading to increased competition, lower trading costs for investors, and the emergence of discount brokerages.

Key Takeaways

Brokerage commissions are fees charged by financial intermediaries for executing buy or sell orders.
Historically, these commissions were fixed, but deregulation in 1975 led to competitive, negotiated rates.
Many brokers now offer "commission-free" trading, but they often generate revenue through alternative methods like Payment for Order Flow.
Understanding brokerage commissions is crucial for assessing the total transaction costs of an investment.
Regulatory bodies like FINRA oversee that commissions charged remain fair and reasonable.

Formula and Calculation

The calculation of brokerage commissions can vary significantly based on the broker, the type of security, and the trade size. Historically, it was often a percentage of the trade value or a fixed amount per share or contract.

For a percentage-based commission:

\text{Commission} = \text{Trade Value} \times \text{Commission Rate}

For a per-share or per-contract commission:

\text{Commission} = \text{Number of Shares/Contracts} \times \text{Commission per Share/Contract}

Where:

Trade Value refers to the total monetary value of the securities being bought or sold, calculated as the execution price multiplied by the quantity.
Commission Rate is the percentage charged by the broker.
Commission per Share/Contract is the fixed fee applied to each unit traded.

In many modern scenarios, the explicit brokerage commission might be zero, meaning the investor directly pays no fee to the broker at the time of trade.

Interpreting Brokerage Commissions

Interpreting brokerage commissions involves understanding their impact on an investor's overall return. Even a small percentage can significantly erode profits over time, especially for frequent traders or those dealing with small capital amounts. For instance, a 1% commission on both buying and selling a security means an investor needs at least a 2% gain just to break even before considering other fees or market movements.

With the advent of "commission-free" trading, interpretation shifts from direct fees to indirect costs. Investors need to consider how their broker generates revenue. While no direct commission is charged, factors such as bid-ask spread variations or the practice of Payment for Order Flow (PFOF) can subtly affect the actual execution price received by the investor, thereby impacting their net return. It's essential for investors to read their broker's disclosures to understand all potential revenue streams and their implications for the investor's overall investment strategy.

Hypothetical Example

Imagine an investor, Sarah, wants to buy 100 shares of XYZ Corp. stock.

Scenario 1: Traditional Brokerage Commission
Sarah uses a traditional broker that charges a fixed commission of $7 per trade.

She buys 100 shares of XYZ Corp. at $50 per share.
Total value of shares purchased = 100 shares * $50/share = $5,000.
Brokerage Commission = $7.
Total cost to Sarah = $5,000 (shares) + $7 (commission) = $5,007.

Scenario 2: Commission-Free Brokerage
Sarah uses a commission-free broker (e.g., one that relies on Payment for Order Flow).

She buys 100 shares of XYZ Corp. at $50 per share.
Total value of shares purchased = 100 shares * $50/share = $5,000.
Brokerage Commission = $0.
Total cost to Sarah = $5,000.

In Scenario 1, the $7 is an explicit cost. In Scenario 2, while there's no explicit commission, the broker might earn revenue from routing Sarah's order to a market maker, potentially leading to a slightly less favorable execution price than she might have received elsewhere, although this difference is often imperceptible to retail investors.

Practical Applications

Brokerage commissions appear in various aspects of the financial world:

Retail Investing: Individual investors directly encounter brokerage commissions when buying or selling stocks, Exchange-Traded Fund (ETF)s, or other securities through their brokerage accounts. The presence or absence of these commissions is a significant factor in choosing a brokerage firm.
Institutional Trading: While often negotiated at lower rates per share due to high volume, institutional investors also incur commissions for large block trades or complex derivatives. These commissions are a factor in their overall trading desk costs.
Fund Management: Actively managed mutual funds or hedge funds incur trading costs, including commissions, which are passed on to investors through expense ratios. These costs can impact a fund's net performance.
Regulatory Oversight: Organizations like the Financial Industry Regulatory Authority (FINRA) regulate how brokerage commissions are charged. FINRA Rule 2121, known as the "5% Policy," serves as a guideline, stating that commissions and markups must be "fair and reasonable" considering all relevant circumstances.⁷ This rule applies to transactions in all securities, including fixed income securities.⁶
Brokerage Business Models: For brokerage firms, commissions—whether explicit or implicit through practices like Payment for Order Flow—are a critical source of income. Firms like Robinhood, known for offering "commission-free" trading, primarily generate their transaction-based revenue from other sources like payment for order flow and markups on cryptocurrency. The⁵ Securities and Exchange Commission (SEC) continues to propose and implement rules related to these practices to ensure transparency and fairness for investors.

##⁴ Limitations and Criticisms

Despite the shift towards lower or zero explicit brokerage commissions, the concept still faces limitations and criticisms:

Hidden Costs: The move to "commission-free" trading has shifted focus to less transparent transaction costs, such as Payment for Order Flow (PFOF). Critics argue that PFOF creates a conflict of interest for brokers, as they may route orders to venues that pay the most rather than those offering the absolute best execution price for the client. Whi³le regulators require disclosure, the impact on individual trades can be difficult for retail investors to quantify.
Profitability Pressure: The race to zero commissions has put immense pressure on brokerage firms' traditional revenue streams, forcing them to seek alternative ways to monetize client activity. This could lead to a focus on other services or products that may not always align with client interests.
Regulatory Scrutiny: The complex nature of alternative revenue models, particularly PFOF, has drawn significant regulatory attention. The SEC and FINRA continually evaluate these practices to ensure they do not compromise the broker's obligation for "best execution."

##² Brokerage Commissions vs. Payment for Order Flow

Brokerage commissions and Payment for Order Flow are both ways a broker-dealer generates revenue from client trades, but they differ significantly in their transparency and mechanism.

Feature	Brokerage Commissions	Payment for Order Flow (PFOF)
Nature of Fee	Direct, explicit fee charged to the client.	Indirect payment received by the broker from a market maker.
Visibility	Clearly stated on trade confirmations.	Often embedded in the trading process, less visible to the client.
Impact on Client	Directly adds to the cost of buying/selling.	Can subtly affect the execution price received by the client.
Broker Revenue	Primary revenue source for traditional brokers.	Key revenue source for "commission-free" brokers.
Client Control	Client is aware of the cost and chooses broker based on it.	Client may be unaware of the payment or its potential impact on price.

While brokerage commissions are a straightforward cost paid by the investor, Payment for Order Flow represents compensation a broker receives for directing client orders to specific market makers or exchanges. In "commission-free" trading environments, PFOF often replaces direct commissions as the broker's primary way to earn money from order execution.

FAQs

1. Are brokerage commissions still common?

Direct brokerage commissions for trading stocks and ETFs have largely disappeared for retail investors at many major online brokers. However, commissions may still apply to certain types of transactions, such as trading options, mutual funds, penny stocks, or over-the-counter (OTC) securities, as well as for specialized services or human broker assistance.

2. How do "commission-free" brokers make money?

"Commission-free" brokers primarily generate revenue streams through other means, with Payment for Order Flow (PFOF) being a significant one. They may also earn income from margin lending, interest on uninvested cash balances, premium subscriptions, and regulatory fees passed on to the client.

3. What is the FINRA 5% Rule?

The FINRA 5% Rule, formally FINRA Rule 2121 ("Fair Prices and Commissions"), is a guideline stating that markups, markdowns, and commissions charged in securities transactions must be fair and reasonable, taking into account all relevant circumstances. It is not a strict rule that prohibits commissions above 5%, but rather a policy used to assess fairness, and exceeding 5% may draw greater regulatory scrutiny.

##¹# 4. Do I pay brokerage commissions on all investments?

No, not all investments incur brokerage commissions. For example, direct investments in a company through a dividend reinvestment plan (DRIP), or purchasing shares of a mutual fund directly from the fund company, often bypass brokerage commissions. Similarly, many online brokers offer commission-free trading for stocks and Exchange-Traded Fund (ETF)s.

5. How can I find out the commissions my broker charges?

Brokerage firms are required to disclose their fee schedules to clients. This information is typically available on their websites, in their account agreements, or upon request. For commission-free platforms, it is important to review their disclosures regarding Payment for Order Flow and other indirect revenue sources.