Today, virtually anyone with a smartphone can buy and sell stocks from almost anywhere. Discount online brokerages such as Robinhood, Schwab, TD Ameritrade, and others have developed trading apps that allow users to trade stocks, or exchange traded funds, mutual funds, and other investment products, with a few finger swipes. Adding to this convenience is that many of these trades are now commission-free. However appealing the words commission-free may sound, it does not mean there are no costs.
Gone are the days of looking up stock quotes in the newspaper and then having the privilege of paying a commission to a stockbroker so a trade could be placed for you. Intentionally or not, this archaic, time-consuming, and expensive system eliminated — or at least limited — trading access to many would-be investors. Fast-forward to today and the mission of one of these brokerages is to democratize finance for all. The availability of these apps certainly has made investing more accessible to many. And like in many other industries, technological advancements in financial services have allowed for cost reductions and mass adoption.
Mass adoption has been driven not only by technology offering convenience and cost reduction, but also by the elimination of account minimums. Not long ago, it was commonplace for brokerages to require a minimum dollar amount in an account or a minimum number of trades per calendar year. Often these account minimums could rise to tens or hundreds of thousands of dollars.
Then, along came these trading apps, greatly reducing barriers to entry. The user interface of these apps varies from brokerage to brokerage, but the account opening and functionality are all quite similar. The first step in the account-opening process is to establish an investor profile. Once this is completed, an account type is selected and opened. As part of the account opening, a personal bank account is typically linked so that the investment account can be funded electronically. From there, an account owner is able to begin trading investments.
In this new world of online brokerages and trading apps, commission-free does not mean no cost. These online businesses are business, and as such, have to answer to shareholders and have profit motives. So, how do they generate revenue if they don’t charge commissions on trades? With mass adoption and increased users, thanks in part to investing apps, new forms of revenue were discovered. There can be a number of different ways that revenue is earned. The first is fairly simple and straightforward: some charge a subscription fee which entitles the subscriber to various forms of premium service.
A second method is a bit more nuanced and described by the industry jargon, Payment for Order Flow. Sounds benign enough, and in concept it is. Whether buying or selling an investment, there is always somebody on the other side of the trade and there is always a difference between the price at which someone is willing to buy an investment (the bid price) and the price at which someone is willing to sell an investment (the ask price). The ask price is typically higher than the bid price, but only by a small amount, sometimes as little as cents. When a buy or sell trade is placed using an app (or even a brokerage’s website), that order is forwarded to a third party which actually executes the trade.
This third party is in the business of matching up the buy or sell trades. So, they are in the unique position to profit from the difference between the bid and ask price difference. The third party then sends a portion of that profit back to the brokerage as “payment” for sending (or flowing) the customer’s order to them. This is Payment for Order Flow. The brokerage that accepts the customer’s trade order, and the third that executes the trade order, both have legal obligations to get the best purchase or sale price for the client and there is no reason to believe that is not happening. However, the brokerage may have an incentive to encourage customers to trade excessively as the higher the volume of trading, the higher its potential revenue.
A third revenue source for some brokerages is called net interest margin. This is common with banks and is the difference between the interest that a brokerage earns and pays on a customer’s uninvested cash. In order to buy investments at some point in the future, a brokerage account must have cash available. Likewise, when an investment is sold, the proceeds are sent to the brokerage account in the form of cash. Often, this cash will sit idle in the brokerage account until a customer is ready to make the next buy trade. The brokerage will pay very little or no interest on that idle cash. However, the brokerage does have the ability and legal right to use that idle cash for themselves in interest bearing investments such as U.S. Treasuries. For Truckee resident and online brokerage customer Jonathan Moulton, “The idea of some brokerage using my cash to make money is extremely aggravating.” He always makes an effort to keep as little cash as possible in his brokerage account.
Although some may question whether these revenue sources are in a customer’s best interest, there is nothing illegal about these practices. In fact, if these practices are part of a brokerage’s business model, they must be disclosed. The best way to determine if a brokerage has one of these revenue sources is to review a document called Reg BI Form CRS, which is short for Regulation Best Interest, Customer Relationship Summary. The Securities and Exchange Commission requires every brokerage to provide this document to customers. Although the reading may be a bit dry, the document will give details on how the brokerage earns revenue. With this information, prospective customers can then determine if they want to invest with that brokerage and use their trading app.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Please consult your financial advisor prior to making financial decisions.
~ John Manocchio (CA Insurance Lic# 0H73423) is an investment adviser representative with Commonwealth Financial Network, Member FINRA/SIPC. Contact him at Pacific Crest Wealth Planning, jcmanocchio@pacificcrestwp.com or (530) 562-5250.
