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Negotiated commission

What Is Negotiated Commission?

A negotiated commission refers to a fee structure where the charge for a financial transaction, such as buying or selling securities, is determined through a bargaining process between the client and the brokerage firms. Unlike a predetermined or standardized rate, the final commission amount is flexible and subject to agreement. This approach to setting fees falls under the broader category of securities trading and impacts the overall transaction costs incurred by investors.

Historically, brokerage commissions were fixed, meaning all clients paid the same rate for a given trade. The shift to negotiated commissions revolutionized the financial services industry by introducing competition among brokers, leading to lower costs for investors and a wider range of service offerings.

History and Origin

Prior to 1975, the United States brokerage industry operated under a system of fixed commission rates, mandated by the New York Stock Exchange (NYSE). This meant that all member firms charged uniform commissions for executing stock trades, regardless of the size or complexity of the order. This practice, established by the Buttonwood Agreement of 1792, limited competition and often resulted in disproportionately high costs for individual investors and even large institutional clients.8

The move away from this long-standing tradition culminated on May 1, 1975, a date often referred to as "May Day" in financial circles. On this day, the Securities and Exchange Commission (SEC) abolished fixed commission rates, mandating that brokerage firms negotiate commissions directly with their clients.7 This pivotal regulatory change was the result of years of debate and increasing pressure from various stakeholders, including the SEC itself, which sought to foster greater competition and efficiency within the securities markets.6 The decision effectively ended 183 years of fixed pricing, ushering in an era where brokers were free to set their own rates.5 This significant event led to a wave of regulatory changes that reshaped the financial landscape.

Key Takeaways

  • Negotiated commissions are transaction fees agreed upon through bargaining between a client and a brokerage.
  • The shift from fixed to negotiated commissions on May 1, 1975 ("May Day"), revolutionized the brokerage industry.
  • This change introduced price competition among brokers, leading to lower trading costs for investors.
  • Negotiated commissions are common for institutional trades and for clients with high trading volumes or complex needs.
  • While offering cost savings, understanding the total fee structure and potential for hidden costs is crucial with negotiated commissions.

Interpreting the Negotiated Commission

The interpretation and application of a negotiated commission largely depend on the specific circumstances of the transaction and the client-broker relationship. For large institutional investors or active traders, the ability to negotiate means they can often secure significantly lower per-share or per-trade costs due to their substantial trading volume. This contrasts with individual retail investors, who may have less leverage for negotiation, especially for smaller trades.

Factors influencing the negotiated rate can include the size and frequency of trades, the type of security being traded, the level of investment advice or research provided by the broker, and the overall client relationship value. The emergence of discount brokers post-May Day, who prioritized lower costs over extensive advisory services, was a direct consequence of this shift towards negotiated rates.

Hypothetical Example

Consider an institutional investor, "Alpha Investments," and an individual investor, "Mr. Smith," both wishing to execute trades.

Scenario:

  • Alpha Investments wants to buy 1,000,000 shares of XYZ Corp.
  • Mr. Smith wants to buy 100 shares of XYZ Corp.

Brokerage A (Full-Service Broker):
Alpha Investments contacts Brokerage A, a full-service broker, for their large order. Given Alpha's significant assets under management and high trading frequency, they negotiate a commission rate of $0.005 per share.

For Alpha Investments:
Commission = 1,000,000 shares * $0.005/share = $5,000

Mr. Smith, with his smaller order, also uses Brokerage A but has less negotiating power. While Brokerage A might have a standard commission for smaller retail orders (e.g., $7 per trade or a percentage), they might offer a slight reduction to $5 if Mr. Smith has a long-standing relationship or multiple accounts.

For Mr. Smith:
Commission = $5 (a fixed negotiated rate for small orders, or a very limited negotiation from a standard rate).

This example illustrates how the size and nature of the client's business directly influence the outcome of a negotiated commission, often leading to lower effective rates for high-volume transactions.

Practical Applications

Negotiated commissions are prevalent across various facets of the financial industry. They are most commonly encountered by large institutional investors, such as mutual funds, hedge funds, and pension funds, who execute significant trading volume. These entities often negotiate favorable commission rates due to the substantial business they bring to brokerage firms. The competitive environment fostered by negotiated rates has contributed to increased market efficiency by reducing the friction of trading.

Beyond equities, negotiated commissions can also apply to transactions involving other financial instruments, including bonds, options, and foreign exchange. The introduction of negotiated rates also spurred innovation, leading to the rise of discount brokers and, eventually, zero-commission online trading platforms, which further democratized access to markets for individual investors.4 For investment management firms, understanding and negotiating these commissions is a critical component of managing client portfolios and minimizing costs. Research from the Federal Reserve Bank of San Francisco has explored how these commission costs impact trading behavior and market dynamics.3

Limitations and Criticisms

While negotiated commissions generally lead to lower explicit trading costs, they are not without limitations and criticisms. One primary concern is the potential for less transparency compared to clearly stated fixed fees. The actual negotiated rate might not always be immediately apparent, and it can vary significantly between clients and even between different trades for the same client, making direct comparisons difficult.

Another criticism arises in scenarios where brokers provide a range of services beyond just execution, such as research or investment advice. If the commission structure is not clear, it can lead to conflicts of interest, where a broker might be incentivized to encourage more trades to generate higher commissions, regardless of the client's best interest. The shift towards fee-based advisory models in recent years, where advisors charge a percentage of assets under management rather than per-trade commissions, partly addresses this concern by aligning advisor incentives with client asset growth.

Moreover, smaller investors or those with less negotiating power may still face relatively higher effective commission rates compared to large institutions or active traders. The complexity of understanding various fee structures, including those involving market makers and order flow payments, can also be a challenge for retail investors. It is crucial for investors to thoroughly review their client agreements and understand all associated costs. Academic studies have also analyzed the unforeseen consequences and long-term impacts that deregulation, including the elimination of fixed commissions, had on the structure of the financial industry and the behavior of market participants.1, 2

Negotiated Commission vs. Fixed Commission

The core difference between a negotiated commission and a fixed commission lies in how the brokerage fee is determined.

FeatureNegotiated CommissionFixed Commission
DefinitionFee determined through bargaining between client & broker.Predetermined, standardized fee for all transactions.
FlexibilityHighly flexible; can vary based on factors like volume.Rigid; applies uniformly regardless of transaction details.
PrevalenceDominant model for institutional trades; common for high-net-worth retail.Historically prevalent; largely abolished in major markets (e.g., pre-1975 U.S.).
CompetitionFosters strong price competition among brokers.Limited price competition among brokers.
TransparencyCan be less transparent due to individual agreements.Highly transparent due to standardized rates.

Confusion between the two often stems from historical context. Before May Day 1975, fixed commissions were the norm, meaning all investors, regardless of trade size, paid the same set percentage or per-share fee. The shift to negotiated commissions meant that brokers and clients now had the freedom to agree on a mutually acceptable rate, introducing a competitive element that was previously absent.

FAQs

What is the primary benefit of negotiated commissions?

The main benefit is the potential for lower trading costs, especially for large-volume traders or institutional investors, as they can leverage their business to secure more favorable rates.

Are all brokerage commissions negotiated today?

While the ability to negotiate exists, many retail brokerage services now offer commission-free trading for stocks and exchange-traded funds (ETFs). For other financial instruments or specialized services, commissions may still apply and could be subject to negotiation, particularly for active traders or larger accounts.

How can an individual investor negotiate a commission?

Individual investors typically have less negotiating power than institutions. However, they can inquire about tiered pricing based on account size or trading activity, compare fee structures across different brokerage firms, or choose discount brokers if they don't require extensive investment advice.

Did negotiated commissions lead to zero-commission trading?

Yes, the introduction of negotiated commissions spurred intense competition among brokers. This competitive environment, combined with technological advancements, eventually led to the widespread adoption of zero-commission trading for many standard equity and ETF trades, further reducing transaction costs for investors.