Commissions

What Are Commissions?

Commissions are fees charged by a financial professional or a brokerage firm for executing a transaction on behalf of a client. These fees are a primary component of transaction costs in financial markets and represent compensation for services rendered, such as buying or selling securities. While historically a significant direct cost for investors, the structure of commissions has evolved considerably, particularly with the widespread adoption of zero-commission trading models in recent years. Understanding commissions is crucial for any investor navigating the landscape of financial markets and trading costs.

History and Origin

For nearly two centuries, fixed commission rates were the norm in the U.S. stock market. Brokerage firms charged a predetermined, non-negotiable fee for each transaction, regardless of the size or value of the trade. This system ensured a stable revenue stream for brokers but often made trading prohibitively expensive, especially for smaller investors.

A pivotal moment in the history of commissions occurred on May 1, 1975, a date widely known as "May Day." On this day, the U.S. Securities and Exchange Commission (SEC) formally adopted Rule 19b-3, which abolished fixed commission rates and ushered in an era of negotiated commissions. This regulatory change aimed to increase competition among brokers and reduce trading costs for investors¹⁰. Initially, some established Wall Street firms raised rates for individual investors while lowering them for large institutions. However, this deregulation ultimately spurred the rise of discount brokers, who offered lower fees and paved the way for more accessible investing for the retail investor⁸, ⁹. The move away from fixed commissions significantly transformed the financial industry, democratizing access to markets and fostering innovation⁶, ⁷.

Key Takeaways

• Commissions are fees paid to a broker for executing investment transactions.
• Historically, commissions were fixed, but deregulation in 1975 (May Day) led to negotiated rates and increased competition.
• The advent of online trading and fierce competition has driven direct stock and exchange-traded funds (ETFs)) commissions to zero at many brokerage firms.
• Even with "zero commissions," investors may still incur indirect costs, such as the bid-ask spread or payment for order flow.
• Regulation, such as Regulation Best Interest (Reg BI), aims to ensure that brokers act in the client's best interest regardless of commission structure.

Formula and Calculation

While "commissions" themselves are typically a flat fee or a percentage of the transaction value, there isn't a universal formula for calculating them, as they are determined by the brokerage firm. However, to understand the impact of commissions on a trade, one might consider the following simple calculation for the total cost:

Alternatively, if the commission is a percentage:

Where:

• Number of Shares: The quantity of equities or other securities being bought or sold.
• Share Price: The price per share at which the transaction is executed.
• Commission Fee: A fixed amount charged for the trade.
• Commission Rate: A percentage applied to the total value of the trade.

These calculations help an investor understand the full cost of executing their investment strategy.

Interpreting Commissions

The interpretation of commissions has drastically changed in the modern investment landscape. In a world where many direct commissions for trading stocks and ETFs have dropped to zero, "interpreting commissions" now often means looking beyond the stated fee to understand the total transaction costs.

For instance, when a brokerage firm advertises "zero commissions," it implies that the investor does not pay an explicit fee for placing a trade. However, the firm still needs to generate revenue. This can be achieved through other means, such as charging fees for premium services, account maintenance, or, most commonly, through practices like payment for order flow. In this scenario, the firm routes orders to a market maker who pays the broker for the opportunity to execute the trade. The market maker profits from the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. While this cost is indirect to the investor, it is still a component of the overall trading expense. Therefore, when evaluating investment platforms, understanding the full spectrum of potential costs, not just explicit commissions, is vital for proper financial planning.

Hypothetical Example

Consider a hypothetical retail investor named Sarah who wants to purchase 100 shares of a company's stock trading at $$50 per share.

Scenario 1: Brokerage with a fixed commission
If Sarah uses a traditional brokerage firm that charges a fixed commission of $$7 per trade, her total cost would be:

• Cost of shares: 100 shares * $50/share =$5,000
• Commission fee: $$7
• Total cost: $5,000 +$7 = $$5,007

Scenario 2: Zero-commission brokerage
If Sarah uses a zero-commission brokerage firm, her direct cost for the trade would be:

• Cost of shares: 100 shares * $50/share =$5,000
• Commission fee: $$0
• Total cost: $$5,000

In Scenario 2, while Sarah pays no explicit commission, the brokerage firm might earn revenue through other mechanisms, such as receiving payment for directing Sarah's order to a specific market maker. The market maker, in turn, profits from the bid-ask spread, which means Sarah might execute her trade at a slightly less favorable price than the absolute midpoint of the spread. This difference, though often small, is an implicit cost.

Practical Applications

Commissions play a significant role in various aspects of investing and financial services:

• Online Brokerage Accounts: The most common application of commissions is in online trading platforms where investors buy and sell equities, exchange-traded funds (ETFs)), options, and other securities. While many major platforms have moved to zero direct commissions for stocks and ETFs, fees may still apply for options, mutual funds outside a specific family, or international trades.
• Financial Advisor Compensation: Some financial advisors are compensated through commissions on the products they sell, such as insurance policies, annuities, or certain types of mutual funds. This contrasts with fee-only advisors who charge a percentage of assets under management or a flat fee for their services.
• Underwriting and Investment Banking: In investment banking, commissions are often paid to firms for underwriting new stock or bond issues. These commissions compensate the firm for bringing the new securities to market and distributing them to investors.
• Real Estate and Sales: Beyond financial markets, the concept of commissions is prevalent in real estate, where agents earn a percentage of the property's sale price, and in various sales industries as a form of incentive compensation.
• Impact on Trading Volume: The reduction of commissions, particularly to zero, has significantly impacted retail trading activity, leading to increased trading volumes as the cost barrier to frequent trading diminishes⁴, ⁵. This shift allows retail investors to potentially trade more frequently without incurring high direct transaction costs.

Limitations and Criticisms

While the move to zero commissions has democratized access to trading for many retail investors, the system is not without its limitations and criticisms. A primary concern is that "zero commissions" does not necessarily mean "free trading." Brokerage firms still need to generate revenue, and they do so through other means, which can include:

• Payment for Order Flow (PFOF): Brokers may route customer orders to specific market makers who pay for the privilege of executing those orders. While regulators require brokers to seek "best execution" for clients, critics argue that PFOF could create a conflict of interest, potentially leading to less favorable execution prices for investors, even if the difference is minuscule on a per-share basis³.
• Bid-Ask Spread: Regardless of commissions, investors always deal with the bid-ask spread. When buying, an investor pays the higher "ask" price, and when selling, they receive the lower "bid" price. This difference is an inherent transaction cost that profits the market maker and is a significant source of revenue in a zero-commission environment².
• Reduced Incentives for Service: Some argue that lower or zero commissions might reduce the incentive for brokers to provide comprehensive research, personalized advice, or extensive customer support, pushing investors towards a more self-directed model without adequate guidance for their investment strategy.
• Encouragement of Overtrading: The absence of direct commission costs might encourage some investors to trade more frequently than is optimal for their long-term performance, leading to higher indirect costs from spreads and potential behavioral biases.
• Regulatory Scrutiny: Regulators, such as the SEC, continue to examine the implications of zero-commission trading models, particularly regarding transparency and whether such models truly align with the "best interest" of the retail investor¹.

Commissions vs. Spreads

Commissions and spreads both represent costs associated with trading securities, but they function differently.

Commissions are explicit fees charged by a brokerage firm for facilitating a trade. These are typically flat fees per transaction or a percentage of the trade value. Historically, commissions were a direct and transparent cost to the investor, paid upfront for the broker's service. With the advent of "zero-commission" trading, direct commissions for many common asset classes like equities and ETFs) have largely disappeared for retail investors.

Spreads, specifically the bid-ask spread, refer to the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask) for a security at a given time. This spread represents an implicit transaction cost that is paid to the market maker who provides liquidity. Even with zero-commission trading, the bid-ask spread remains. Investors effectively "pay" the spread by buying at the ask and selling at the bid, rather than at a single market price. The confusion arises because while commissions are now often zero, the bid-ask spread is still a cost, and in a zero-commission environment, it becomes a more prominent component of the total trading cost for the investor, as well as a key revenue source for the financial ecosystem.

FAQs

Q: Are all commissions gone with "zero-commission" trading?

A: No. While direct commissions for trading stocks and exchange-traded funds (ETFs)) are largely zero at many major brokerage firms, commissions may still apply for other types of securities, such as options, certain mutual funds, or international equities. Investors should always review their brokerage firm's fee schedule.

Q: How do brokers make money if they charge no commissions?

A: Brokerage firms use various other revenue streams. These can include payment for order flow (receiving payments from market makers to route customer orders to them), interest earned on uninvested cash balances, lending out shares for short selling, and charging for premium services or account maintenance fees.

Q: Does "zero commission" mean my trades are entirely free?

A: No, "zero commission" refers only to the explicit fee charged by the broker. Other transaction costs still apply, most notably the bid-ask spread. This is the difference between the buying and selling price of a security, and it is a cost inherent in almost all trading.

Q: How does Regulation impact commissions?

A: Regulation, such as the SEC's Regulation Best Interest (Reg BI), aims to ensure that brokerage firms and financial advisors act in the "best interest" of their retail investor clients when making recommendations, regardless of the commission structure. This rule seeks to mitigate potential conflicts of interest that might arise from commission-based compensation.