Fixed commissions

What Are Fixed Commissions?

Fixed commissions refer to a traditional pricing model in financial markets where brokerage firms charged a predetermined, flat fee for executing a trade, regardless of the size or value of the transaction. This system was once prevalent across various financial markets, particularly in the securities industry, and is a historical component of brokerage compensation. Under a fixed commission structure, an investor would pay the same fee whether they bought 100 shares or 1,000 shares of a particular stock. This model aimed to standardize transaction costs and ensure a consistent revenue stream for brokerage firms.

History and Origin

The concept of fixed commissions in the United States dates back to the very origins of the New York Stock Exchange (NYSE). The Buttonwood Agreement of 1792, which laid the foundation for the NYSE, included a principle mandating a fixed-price commission schedule. This agreement effectively established a system where all broker-dealers charged clients the same set fee for transactions, regardless of their size or nature. The rationale behind this was to maintain fairness and orderliness within the market.³⁵

For over 180 years, this fixed commission structure remained largely intact on the NYSE, with the Securities and Exchange Commission (SEC) even approving rate increases.³⁴ However, by the late 1960s and early 1970s, dissatisfaction grew, especially among institutional investors who were dealing with large trade volumes and seeking lower costs. To bypass the minimum prices set by the NYSE, these institutions began trading in the "third market" (over-the-counter for NYSE-listed stocks) and the "fourth market" (direct trades among themselves).³³

The pivotal moment arrived on May 1, 1975, a date famously known as "May Day." On this day, the SEC mandated the complete abolition of fixed commission rates, forcing the brokerage industry to transition to competitive, negotiated rates.³¹, ³² This deregulation was a significant turning point, aimed at fostering greater competition among brokers and reducing trading costs for investors.²⁹, ³⁰ As Charles Schwab, a pioneer in the discount brokerage space, recounted, this change "liberated the whole industry" and opened the door for discounted trades.²⁸ The shift spurred innovation, including the emergence of discount brokerage models and eventually led to the widespread adoption of electronic trading platforms.²⁷

Key Takeaways

• Fixed commissions were a standardized, flat fee charged by brokers for executing trades, irrespective of transaction size.
• The system was prevalent in the U.S. securities industry for over 180 years, originating with the Buttonwood Agreement for the NYSE.
• "May Day" (May 1, 1975) marked the abolition of fixed commissions by the SEC, ushering in an era of negotiated rates.
• The transition aimed to increase competition, reduce costs for investors, and promote efficiency in financial markets.
• The end of fixed commissions paved the way for modern brokerage models, including discount and eventually zero-commission trading.

Interpreting Fixed Commissions

In the context of fixed commissions, interpretation revolved around the absolute cost of a trade rather than its percentage of the transaction value. Since the fee remained constant, smaller trades incurred a disproportionately higher percentage cost, while larger trades benefited from a lower effective percentage. This created an implicit bias where high-volume institutional investors effectively paid a lower relative fee compared to retail investors making smaller trades, even though the nominal fixed commission was the same.

Before their abolition, understanding fixed commissions meant knowing the specific dollar amount a broker would charge per transaction. This transparency in the nominal fee was considered a benefit by some, simplifying cost anticipation for clients. However, the lack of price competition meant investors had no incentive to seek better rates, as all member firms of a stock exchange charged uniformly.

Hypothetical Example

Imagine a time before May Day 1975, when fixed commissions were the norm on the New York Stock Exchange. A brokerage firm has a fixed commission of $50 per stock trade.

Scenario:

An individual investor, Sarah, wants to buy shares of Company A.

• Trade 1: Sarah buys 100 shares of Company A at $10 per share.
  • Total value of shares purchased: (100 \text{ shares} \times $10/\text{share} = $1,000)
  • Fixed commission: $50
  • Total cost to Sarah: ( $1,000 + $50 = $1,050 )
  • Effective commission rate: ( ($50 / $1,000) \times 100% = 5% )

A few days later, a large institutional investor, Global Funds, wants to buy shares of the same Company A.

• Trade 2: Global Funds buys 10,000 shares of Company A at $10 per share.
  • Total value of shares purchased: (10,000 \text{ shares} \times $10/\text{share} = $100,000)
  • Fixed commission: $50
  • Total cost to Global Funds: ( $100,000 + $50 = $100,050 )
  • Effective commission rate: ( ($50 / $100,000) \times 100% = 0.05% )

As this example illustrates, while both Sarah and Global Funds paid the same fixed commission of $50, the effective cost as a percentage of their trade value was drastically different. Sarah, the retail investor, paid a much higher relative transaction cost for her smaller trade.

Practical Applications

While fixed commissions are largely a historical artifact in mainstream equity trading, the underlying principle of a flat fee still appears in certain financial contexts and compensation structures.

• Real Estate Brokerage: In some real estate markets, real estate agents may operate under a fixed commission model for their services, where they receive a set fee regardless of the property's final sale price. However, this model faces increasing scrutiny and challenges, with arguments for more competitive and negotiable commission structures.²⁵, ²⁶
• Bond Trading: Certain fixed-income transactions or specific types of large block trades might still involve a flat fee component, particularly for institutional clients.²⁴
• Advisory Fees: Some financial advisors may charge a flat annual fee for their services, rather than a percentage of assets under management or commissions on trades. This fixed fee approach offers predictability for both the advisor and the client.²³
• Payment for Services: Beyond direct trading, other services within capital markets, such as certain research reports or administrative tasks, might have fixed charges associated with them, independent of specific transaction volumes.

The broader lesson from the era of fixed commissions is the impact of pricing models on market dynamics and accessibility. The shift away from fixed commissions in equity markets led to a dramatic increase in trading volume and broader participation by retail investors.²²

Limitations and Criticisms

Fixed commissions, despite their simplicity, faced significant limitations and widespread criticism, ultimately leading to their abolition in many financial markets.

• Lack of Competition: The most prominent criticism was that fixed commissions stifled competition among brokerage firms. Since all firms charged the same fee, they could not compete on price, leading to higher costs for investors.²¹ This lack of price competition was viewed as an anti-competitive practice.²⁰
• Inefficiency: The system did not account for the varying effort and resources required for different trades. Small trades were often overcharged relative to the effort involved, while large trades, though incurring the same nominal fee, provided substantial revenue for minimal additional work, leading to what critics called "fat fees."¹⁸, ¹⁹
• Barrier to Entry for Small Investors: The high, standardized fees could act as a barrier for retail investors with smaller capital, making investing uneconomical for them and limiting their participation in the market.¹⁵, ¹⁶, ¹⁷
• "Soft Dollar" Arrangements: Fixed commissions created an environment where brokers could offer "soft dollar" arrangements to institutional investors. This meant that in exchange for directing large orders and their associated substantial fixed commissions, brokers would provide additional services like research reports, market data, or analytical tools to these institutions at no explicit extra cost. Critics argued this practice could lead to conflicts of interest and obscure the true cost of trading and services.¹³, ¹⁴
• Protection of Inefficient Firms: By removing price pressure, fixed commission rates were criticized for protecting inefficient brokerage firms that might not have survived in a truly competitive environment.¹²

The move away from fixed commissions in 1975 was met with strong opposition from Wall Street, with some fearing it would undermine the stability of the securities industry.¹¹ However, studies indicated that price competition led to lower prices and a fee structure that better reflected the actual costs of executing different types of transactions.¹⁰

Fixed Commissions vs. Negotiated Commissions

Fixed commissions and negotiated commissions represent two fundamentally different approaches to pricing brokerage services.

The confusion often arises because, before 1975, the idea of negotiating commission rates was largely non-existent in the mainstream stock exchange environment. The shift from fixed to negotiated commissions was a direct regulatory intervention to introduce competition and improve market efficiency. While "negotiated commissions" became the immediate successor, the competitive environment it fostered eventually led to the widespread adoption of "zero commissions" for many standard equity and exchange-traded fund (ETF) trades in the late 2010s, where direct commissions are effectively zero, and brokers generate revenue through other means like Payment for Order Flow (PFOF) or other service fees.⁹

FAQs

1. Why were fixed commissions abolished?

Fixed commissions were primarily abolished due to concerns about anti-competitive practices, inefficiency, and the high transaction costs they imposed on investors. Regulators sought to introduce competition into the brokerage industry to lower costs and foster innovation.⁷, ⁸

2. When did fixed commissions end in the U.S. stock market?

Fixed commissions formally ended in the U.S. stock market on May 1, 1975, a date often referred to as "May Day." This was mandated by the Securities and Exchange Commission (SEC).⁵, ⁶

3. What replaced fixed commissions?

Fixed commissions were replaced by negotiated commissions, where brokerage firms and clients could directly agree upon fees for trades. This shift spurred the rise of discount brokerage models and eventually led to today's widespread "zero commission" trading for many asset classes.³, ⁴

4. How did the abolition of fixed commissions impact financial markets?

The abolition of fixed commissions led to increased competition, significantly lower trading costs for investors, and a surge in trading volume. It also spurred innovation in brokerage services, including the development of electronic trading platforms and new business models.¹, ²