What Is Commission?
A commission is a fee charged by a broker or agent to a client for facilitating a financial transaction. Within the realm of investment costs, commissions represent a direct expense incurred when buying or selling assets like stocks, bonds, or mutual funds. This remuneration compensates the service provider for their role in executing trades, providing investment advice, or offering other value-added services. The structure and amount of a commission can vary significantly depending on the type of asset, the financial institution, and the specific services rendered.
History and Origin
For much of the history of U.S. financial markets, commissions were fixed, meaning all brokers charged the same rate for a transaction. This system originated with the Buttonwood Agreement in 1792, which laid the foundation for the New York Stock Exchange and set a standard commission rate. For nearly two centuries, these fixed rates provided a predictable revenue stream for broker-dealers and were intended to ensure stability within the securities industry. However, as markets grew and institutional investors sought more competitive pricing, pressure mounted to deregulate these fixed charges.
The pivotal moment arrived on May 1, 1975, a date widely known as "May Day," when the U.S. Securities and Exchange Commission (SEC) mandated the complete abolition of fixed commission rates on stock stock exchanges. This move was a landmark decision aimed at fostering competition among brokerage firms and reducing transaction costs for investors. Prior to this, the SEC had already begun to allow negotiated rates for larger transactions, but "May Day" opened the door for all trades to be subject to competitive pricing.9,8 The deregulation spurred significant changes, leading to the rise of discount brokers and the eventual unbundling of services, where execution, research, and advice were priced separately.7,6
Key Takeaways
- A commission is a payment made to a broker or agent for executing a financial transaction.
- Historically, commissions in the U.S. were fixed until "May Day" in 1975, which led to deregulation and increased competition.
- Commissions contribute directly to an investor's overall investment costs and can impact portfolio returns.
- While traditional per-trade commissions have largely diminished for stocks and exchange-traded funds (ETFs), they remain prevalent in other areas like real estate, insurance, and certain financial products.
- The shift to zero-commission trading for many assets has led to other revenue models for brokerage firms, such as payment for order flow.
Formula and Calculation
The calculation of a commission is generally straightforward, often expressed as a percentage of the transaction value or a flat fee per trade.
If based on a percentage:
Where:
- Transaction Value = The total monetary value of the assets being bought or sold.
- Commission Rate = The percentage charged by the broker.
If based on a per-share or per-contract fee:
Where:
- Number of Shares/Contracts = The quantity of the asset traded.
- Per-Share/Contract Fee = The fixed amount charged per unit.
For example, a broker might charge 0.5% of the total value of a stock trade, or they might charge $\text{$5}$ per trade regardless of the trading volume.
Interpreting the Commission
Understanding commissions is crucial for evaluating the true cost of investing and assessing the profitability of trades. A seemingly small percentage can add up significantly over many transactions or with large investment amounts, directly eroding returns. For instance, a 1% commission on both a buy and a sell trade means an investor needs the asset price to increase by at least 2% just to break even on the transaction costs before any market gains.
When interpreting a commission, investors should consider not only the explicit cost but also the value proposition. A higher commission might be justified if it comes with comprehensive investment advice, in-depth research, or personalized financial planning services from a full-service broker. Conversely, for investors who prefer to manage their own portfolios, a low or zero-commission structure offered by a discount broker is often more appealing.
Hypothetical Example
Consider an investor, Sarah, who decides to purchase 100 shares of Company XYZ, which trades at $\text{$50}$ per share. Her brokerage firm charges a fixed commission of $\text{$7}$ per equity trade.
-
Calculate the total value of the shares:
$\text{100 shares} \times \text{$50/share} = \text{$5,000}$ -
Add the commission to the total cost:
$\text{$5,000 (shares)} + \text{$7 (commission)} = \text{$5,007}$
Sarah's total outlay for this purchase is $\text{$5,007}$. When she eventually sells these shares, she will likely incur another commission, further impacting her net return. If she later sells the 100 shares at $\text{$55}$ per share, her proceeds would be:
-
Calculate the total value of the shares sold:
$\text{100 shares} \times \text{$55/share} = \text{$5,500}$ -
Subtract the selling commission:
$\text{$5,500 (shares)} - \text{$7 (commission)} = \text{$5,493}$
After both transactions and commissions, her net gain would be $\text{$5,493} - \text{$5,007} = \text{$486}$. This example illustrates how commissions are an inherent part of the trading volume calculation for investors.
Practical Applications
Commissions appear in various facets of the financial world beyond direct stock trading.
- Real Estate: Real estate agents typically earn a commission, usually a percentage of the property's sale price, upon the successful closing of a sale. This is often split between the buyer's and seller's agents.
- Insurance: Insurance agents and brokers receive commissions from insurance companies for selling policies. This commission is often embedded in the premium paid by the policyholder.
- Sales: Many sales professionals across different industries, from retail to business-to-business, are compensated fully or partially through commissions based on the volume or value of their sales.
- Investment Products: While direct stock commissions have decreased, some investment products, like certain mutual funds or annuities, still carry commissions, often referred to as loads or sales charges. These can be front-end (paid at purchase), back-end (paid at sale), or level-load (paid annually).
- Brokerage Services: Although many large U.S. broker-dealers eliminated trading commissions for stocks and exchange-traded funds in late 2019, this shift represents an evolution in their business models, not the elimination of all fees.5 Firms now generate revenue through other means, such as payment for order flow, interest on cash balances, and asset management fees.4,3
Limitations and Criticisms
While commissions serve as compensation for services, they have faced criticism over potential conflicts of interest and their impact on market efficiency. In a commission-based model, there can be an incentive for brokers to encourage more frequent trading (known as "churning") to generate higher commissions, even if such activity is not in the client's best financial interest. This can lead to excessive transaction costs that erode an investor's returns.
The move to zero-commission trading for many securities on the stock market has largely addressed the churning incentive for those particular assets. However, new models have brought different concerns. For example, "payment for order flow" (PFOF), where a broker receives compensation from a market maker for directing client orders to them, has drawn scrutiny. Critics argue that PFOF could incentivize brokers to route orders in a way that benefits the market maker (and thus the broker) rather than ensuring the best possible price for the client.2 Regulatory bodies continue to examine these new compensation structures to ensure fairness and transparency for investors.1
Commission vs. Fee
While often used interchangeably in general discourse, "commission" and "fee" have distinct meanings in finance, particularly in the context of financial planning and investment management. A commission is specifically a payment contingent on a transaction, typically a percentage of the transaction value or a fixed amount per trade. It is earned only when a buy or sell order is executed. In contrast, a fee is a broader term for a charge for services rendered, regardless of whether a transaction occurs. Fees can be recurring, such as annual advisory fees based on assets under management (AUM), or one-time, like a setup fee for an account. The shift from commission-based models to fee-based accounts in the advisory industry reflects a move towards aligning the advisor's compensation more closely with the client's asset growth rather than the volume of trades.
FAQs
What is the primary purpose of a commission in finance?
The primary purpose of a commission in finance is to compensate a broker or agent for facilitating a transaction or providing a service. It is their payment for connecting buyers and sellers and executing trades.
Why have commissions for stock trading largely disappeared?
Commissions for stock trading have largely disappeared for many retail investors due to intense competition among broker-dealers and technological advancements that have lowered the cost of executing trades. This shift was accelerated by regulatory changes, such as the "May Day" deregulation in 1975, which fostered competitive pricing.
Do all financial products involve commissions?
No, not all financial products involve commissions. While common in areas like real estate, insurance, and some investment products (e.g., certain mutual funds with loads), many modern investment platforms offer zero-commission trading for stocks and exchange-traded funds. Other products may involve ongoing fees instead of, or in addition to, commissions.
How does a commission affect my investment returns?
A commission directly reduces your investment returns because it is a cost incurred when buying and selling assets. The total amount you pay in commissions over time can significantly impact your net profitability, especially with frequent trading or large transaction values.
Are commissions always a percentage of the transaction?
Not always. While commissions can be a percentage of the transaction value, they can also be charged as a flat fee per trade, a per-share fee, or a per-contract fee, depending on the asset and the brokerage firm's pricing structure.