Commission free trading

What Is Commission-Free Trading?

Commission-free trading refers to the practice where investors can buy and sell financial instruments, such as stocks, exchange-traded funds (ETFs), and options, without incurring a direct fee or commission charged by their brokerage firm for each transaction. This model revolutionized the investment services landscape, making market participation more accessible and significantly reducing trading costs for retail investors. It falls under the broader financial markets category. While the term "commission-free" suggests no cost, brokers employing this model typically generate revenue through alternative means, such as payment for order flow.

History and Origin

The concept of commissions in securities trading has a long history, with fixed commission rates being the norm for centuries. Before 1975, brokerage firms in the U.S. charged standardized fees for stock transactions, regardless of the broker or transaction size. A pivotal shift occurred on May 1, 1975, often referred to as "May Day," when the Securities and Exchange Commission (SEC) abolished these fixed commission rates, mandating negotiated commissions. This regulatory change aimed to foster competition within the brokerage industry and reduce costs for investors.¹¹, ¹²

The unfixing of commissions in 1975 paved the way for the emergence of discount brokers, who offered lower trading costs compared to traditional full-service firms. Over the subsequent decades, technological advancements and the rise of online trading platforms continued to drive commissions downward. The true widespread adoption of commission-free trading, however, accelerated dramatically in 2019. In October of that year, major brokerage firms like Charles Schwab, TD Ameritrade, Fidelity Investments, and E*TRADE eliminated commissions on online trades of U.S. stocks and ETFs, a move that sent shockwaves through Wall Street and prompted widespread adoption across the industry.¹⁰ This shift fundamentally reshaped how many investors engage with the market.

Key Takeaways

• Commission-free trading allows investors to buy and sell select securities without paying a direct fee per trade to their brokerage.
• The elimination of fixed commissions began in 1975, leading to the rise of discount brokers.
• Widespread commission-free trading became standard for many major online brokers in 2019.
• Brokerage firms often generate revenue through other means, such as payment for order flow, rather than direct commissions.
• This model has significantly lowered entry barriers and trading costs for retail investors.

Interpreting Commission-Free Trading

While the phrase "commission-free" implies no cost, it's crucial to understand the underlying mechanisms that enable brokerage firms to offer such services. The primary method through which brokers generate revenue in a commission-free environment is often through payment for order flow (PFOF). In this practice, a brokerage firm receives compensation from a market maker for routing its clients' buy and sell orders to that particular market maker for execution.⁹ The market maker profits from the bid-ask spread—the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept for a security. A portion of this profit is then rebated to the brokerage for directing the order flow to them.

For investors, understanding commission-free trading means recognizing that while they may not pay an explicit commission, the cost might be embedded in the order execution. For instance, while PFOF can lead to price improvement for the investor (getting a slightly better price than the publicly quoted best bid or offer), critics argue it can also create a conflict of interest, as brokers might be incentivized to route orders to market makers who pay the most rather than those offering the absolute best price for the investor. The Securities and Exchange Commission (SEC) requires brokers to disclose their payment for order flow practices to ensure transparency.

Hypothetical Example

Consider an individual, Sarah, who wants to invest in a diversified portfolio of stocks and exchange-traded funds (ETFs). Before the widespread adoption of commission-free trading, Sarah might have paid $5 to $10 in commission for each stock or ETF trade she made through her brokerage firm. If she decided to buy 10 different stocks and ETFs for her initial portfolio, she would incur $50 to $100 in trading costs upfront.

With commission-free trading, Sarah can now use an online brokerage that advertises zero commissions on stock and ETF trades. She places her orders for the 10 different securities without seeing a direct commission charge for each transaction. This enables her to allocate her entire investment capital directly into the financial instruments, potentially buying more shares or units than she would have if commissions were deducted. Although she doesn't pay a commission, the brokerage might still profit by routing her orders to a specific market maker, who then earns revenue from the bid-ask spread on her trades. This means that while the upfront cost is eliminated, there's an indirect revenue stream for the broker.

Practical Applications

Commission-free trading has broad practical applications across various facets of investing and financial planning:

• Increased Accessibility for Retail Investors: It has significantly lowered the barrier to entry for individual investors, allowing those with smaller capital to participate in the stock market without transaction costs eating into their returns. This encourages broader market participation and financial literacy among the public.
• Cost-Effective Diversification: Investors can now more easily build and rebalance a diversified portfolio across various asset classes without incurring high trading fees. This allows for frequent adjustments to portfolio allocations or the addition of new equities or ETFs without prohibitive costs.
• Active Trading: For those who engage in more frequent transactions, such as day traders or swing traders, commission-free trading drastically reduces the overhead, making shorter-term strategies potentially more viable by eliminating per-trade costs.
• Dollar-Cost Averaging: Investors employing a dollar-cost averaging strategy, where they regularly invest a fixed amount into a security, benefit immensely. Without commissions, every dollar contributed goes directly to purchasing shares, maximizing the impact of consistent investment.
• Market Liquidity: The increased volume of retail trades facilitated by commission-free trading can contribute to greater market liquidity, as more buyers and sellers are present in the market.

While offering apparent benefits, it's important to understand the broader implications and how brokerage firms continue to operate profitably. Brokers often rely on revenue streams beyond direct commissions, such as payment for order flow, interest on uninvested cash, and premium services.

⁸## Limitations and Criticisms

Despite the widespread adoption and perceived benefits of commission-free trading, it faces several limitations and criticisms, primarily centered around transparency and potential conflicts of interest.

A significant concern revolves around payment for order flow (PFOF). Critics argue that while investors don't pay a direct commission, the broker may receive compensation from a market maker for routing orders, which could incentivize the broker to prioritize the market maker who pays the most over ensuring the absolute best order execution price for the investor. T⁷his practice has led to regulatory scrutiny, with entities like the European Securities and Markets Authority (ESMA) expressing concerns that PFOF creates an incentive for brokers to choose the best-paying party rather than what is best for the investor, potentially violating rules on best execution and cost transparency.

⁶Another limitation is the potential for investors to overtrade. The absence of per-transaction costs might encourage some investors, particularly those new to the market, to engage in excessive trading, which can lead to poorer long-term investment outcomes due to impulsive decisions or attempts to time the market. E⁵ven without commissions, other fees might still apply, such as exchange fees, regulatory fees, or options contract fees, which can still add up for active traders.

Furthermore, while major asset classes like stocks and ETFs are generally commission-free, some financial instruments, such as certain mutual funds or specific types of bonds, may still carry commissions or other fees. This means that "commission-free" does not necessarily equate to "fee-free" investing across all asset types or services provided by a brokerage firm. The underlying business model reliant on PFOF also raises questions about market efficiency and fairness, with ongoing debates among regulators and market participants about its ultimate impact on the broader financial ecosystem.

⁴## Commission-Free Trading vs. Payment for Order Flow

While often discussed together, commission-free trading and payment for order flow (PFOF) are distinct concepts, though one often enables the other.

Commission-Free Trading refers to the consumer-facing policy where a brokerage firm does not charge its clients a direct fee for buying or selling certain securities. From the investor's perspective, placing a trade incurs no explicit cost on the transaction itself. This model aims to reduce the direct financial barrier to entry for trading stocks, ETFs, and other assets.

Payment for Order Flow (PFOF) is a compensation mechanism behind the scenes, primarily used by brokerages offering commission-free trading. It involves a brokerage receiving a rebate or fee from a market maker in exchange for routing client orders to that particular market maker for execution. The market maker profits from the bid-ask spread and shares a portion of this profit with the brokerage. Essentially, PFOF is how many commission-free brokers generate revenue to offset the lack of direct trading commissions.

³The confusion arises because PFOF is the revenue source that largely supports the commission-free trading model. Without PFOF, many brokerages would find it difficult to sustain a zero-commission offering. However, it's important to distinguish between the service offered to the client (no direct commission) and the internal revenue generation method of the brokerage (PFOF).

FAQs

How do brokerages make money if they offer commission-free trading?

Brokerages that offer commission-free trading typically generate revenue through alternative means. The most common is payment for order flow (PFOF), where they receive compensation from market makers for routing customer orders to them. Other revenue streams can include interest on customers' uninvested cash balances, margin lending, and fees for premium services or other financial instruments not covered by the commission-free policy.

²### Is commission-free trading truly "free"?
While you don't pay a direct commission per trade, it's not entirely "free." The brokerage still incurs costs to facilitate trades, and they make up for lost commission revenue through other means, primarily payment for order flow. This means an indirect cost might be embedded in the price you receive for your trade, or the brokerage might earn revenue from your cash or other services.

¹### What types of investments are typically commission-free?
Most commonly, commission-free trading applies to U.S. listed stocks, exchange-traded funds (ETFs), and sometimes options (though options typically still have a small per-contract fee). Mutual funds might be commission-free if they are part of a specific platform's no-transaction-fee program, but actively managed funds or those outside these programs may still carry sales loads or commissions.

Does commission-free trading affect the quality of my trade execution?

This is a point of debate and regulatory scrutiny. While some argue that payment for order flow could lead brokers to prioritize higher-paying market makers over best execution for the client, others contend that competition among market makers and regulatory oversight, such as SEC Rule 606, help ensure fair pricing and efficient order execution.