Welcome to A New World of Free Stock Trading
In the last few years several new brokers have begun offering free stock trading accounts. While trading commissions have been falling for years, free trading is something new.
The deregulation of commission structures and advances in technology allowed brokers to reduce commissions considerably. However, new profit centres have allowed some brokers to offer commission free trading for stocks. Commission free trading has existed in other markets, notably Forex and CFDs for some time. In most cases those trades are funded via the spread.
In the case of free stock trading accounts, clients really do pay nothing. Brokers have managed to find other ways to generate revenue using cash balances, margin accounts, stock lending and fremium services.
Most of the free share trading services are offered on mobile apps which have a very simple interface and basic features. These types of products are ideal for the millennial market who prefer very easy to use products without an array of choices. In time we will probably see more sophisticated products being launched.
The trend toward free trading services is likely to accelerate as blockchain technology becomes a more integral part of the equity market. Blockchain technology allows many services to be offered even more cheaply, and value can be created in other ways beyond revenue.
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The History of Trading Fees
Trading stocks for free is a relatively new phenomenon, so it’s worth looking at the history of trading costs. Until the 1970s, trading commissions were regulated, and brokers were not able to compete on price. Regardless of which broker you chose, you had to pay the same price to trade.
A 2002 study by Columbia Business School tracked average costs of stocks trades at the New York Stock Exchange. The data shows that from 1920 until 1970 commissions ranged from 0.7% to 1.4%. In those days the brokers owned the exchange and the exchange decided what every broker could charge. Client’s had little choice but to accept these very high trading fees.
Incidentally, it wasn’t just the high fees that investors had to pay. Because there was so little liquidity the spread between bids and offers was much wider as well. That spread is another cost that customers are paying, and can sometimes be even higher than the commission.
In 1975 regulators abolished the fixed commission rates structure and allowed brokers to compete on price. The result was that the minimum commission per trade fell from $40 in 1970 to $10 by 2002. In the following decade commissions fell to around $5, and since that we have seen the introduction of free share trading options.
How Technology Reduces Costs
It’s not just regulations that have brought trading costs down.
- The termination of fixed commissions led to a price war, and brokers had an incentive to reduce their costs which allowed them to reduce fees even more.
- Technology has allowed brokers to cut costs more than any other factor. In particular, online trading platforms allow brokers to let clients enter orders themselves. That means they don’t need a trading desk staffed by traders taking orders over the phone.
- As trading moved from open outcry trading pits to electronic exchanges, brokers were also able to trade higher volumes without employing additional staff. In addition, technology has reduced the cost of settling trades significantly.
- The final push toward rock bottom trading fees came with the emergence of discount brokers. Previously, the highest cost for a broking firm came from teams of research analysts. When online trading platforms came about, broking firms realised that many potential clients didn’t need research, and were happy with a platform that offered just the basics if it meant they would be able to trade at discounted rates.
- But its doesn’t end there – further developments in the industry have now allowed some brokers to offer free stock trading.
How do Brokers offering Free Share Trading Make Money?
If you start doing a stock broker comparison, you’ll quickly find that you can now trade stocks for free with some brokers. You’re probably wondering if there is a catch. Actually, there isn’t really a catch. Let’s look at some of the ways brokers are able to offer stock trading for free.
Obviously, brokers are for profit businesses. No matter how much they manage to cut costs, they still want to make money. Well, they can still generate revenue in a few ways without charging commission.
• Firstly, they earn interest on cash balances held in client accounts. In some cases these accounts pay no interest to the client, allowing the broker to keep any interest they earn on the cash balance. In other cases, the interest is shared by the client and the broker.
• Brokers that offer margin trading can earn additional interest on client trading positions. When a client trades on margin they are essentially borrowing money from the broker. The broker in turn borrows that money at a wholesale rate, and then lends it to the client at a retail rate.
• Brokers can also lend client stock to short sellers. When someone sells a security short, they must first borrow that stock, and to do that they pay a borrowing fee which goes to the broker.
Order Routing Fees
Perhaps the most lucrative method for a broker to earn revenue is by charging dealers that want to execute orders on their behalf. This is a phenomenon that has come about because of high frequency trading or HFT.
High frequency trading firms make money by arbitraging the prices on different exchanges. They have managed to set up the fastest connection between all the exchanges and their own servers by using fibre optic cables that are laid along the shortest possible route between exchanges. That means they can see prices that are more up to date than the official prices usually quoted on data terminals.
When a broker executes an order for a client they are obligated to trade at the National Best Bid and Offer (NBBO). Unfortunately, the official NBBO is not necessarily the most up to date price. HFT firms take advantage of this to earn tiny margins trading on different exchanges. However, to find out what orders are in the system, they first need to execute trades at the NBBO. So, they are happy to pay other brokers o execute trades at those prices.
This is one of the most lucrative ways for brokers to generate revenue without having to charge their clients.
Premium Services Also Pay the Bills
Finally, some brokers that offer a free share dealing account charge monthly fees or charge for certain premium services. Some brokers have tried charging a flat monthly fee, with no charges for each trade. However, the more popular model is a basic free account, with options for upselling.
Many industries have found the ‘fremium model’ works well. The company will offer a limited range of services for free, and then offer value added services at a price. The model works because the company gets the client to sign up which means that have a communication channel open. That gives them lost of opportunity to learn about the client and market products to them. They may not buy the first or second premium product, but eventually they will. In the era of the attention economy, users have value even if they are not paying you.
There have also been some experiments with brokers charging listed companies to list their shares on free stock trading platforms. The idea makes sense – by supporting a free trading service, listed companies should be able to encourage more investors to invest in their shares. Unfortunately, fewer than a hundred companies have bought into the idea, leaving these platforms with a small selection of shares.
Free exchange traded fund (ETF) accounts
Several mainstream brokers now offer a free share dealing account for certain ETFs. These accounts offer commission free trading in as many as 180 ETFs, though they are not always the best or cheapest ETFs to own. However, depending on you needs they may offer ETFs that are a good match for you. In addition, several of these brokers offer mutual funds with no transaction fees.
So how do brokers without free stock trading accounts, offer free ETFs trading accounts? Once again, there are a number of ways brokers can still earn revenue even if they don’t charge commission for ETF trades.
In some cases, these brokers have launched their own ETFs, allowing them to earn management fees. Most ETFs charge a management fee which is withdrawn from the fund’s holding on a monthly basis. In many cases the commission free ETFs have slightly higher management fees than equivalent funds that do incur commission. Brokers can also earn rebates from the ETF management companies, and earn revenue by lending out stock within an ETF that they have issued.
It’s worth remembering that any free share dealing account is commission free for both stocks and ETFs. This is something to investigate when doing a broker comparison regarding stocks and ETFs.
What to Look for When Choosing a Free Share Trading Account
Now that you know how these accounts work, you are probably ready to start looking for the best stock broker for your needs. Free trading accounts are perfectly legitimate and there is no catch. Brokers can earn revenue in ways that does not affect the client.
However, in the case of a broker offering free trading, it is more important than ever to read the terms and conditions. In order for a broker to generate revenue using your cash balance, your stock holding and your order flow, they will need to have your permission.
The important thing, is to make sure you are aware of the permissions you have granted them. It is possible that a broker will use the consent clause to sneak further permissions into the agreement. That could put your account at risk.
This is especially true of smaller, unknown brokers. Before choosing a broker, you should make sure they are reputable, well capitalised and properly licenced. You should also make sure you know exactly how they will make money, and what they are not allowed to do.
You should also check that they offer the tools you need, and that they offer a decent range of stocks to trade. There’s no point signing up to a broker that doesn’t allow you to buy the stocks you want to invest in.
Free Stock Trading, the Bottom Line
Free stock trading is relatively new, but the concept is growing rapidly. We can see more and more new brokers offering commission free trading in shares. And once they begin to gain critical mass we can expect to see mainstream brokers offering free trading too. We will also see more sophisticated platforms being available with commission free trading accounts.
As markets evolve, there are more opportunities for brokers to earn revenue without actually charging commissions. And, technology is still bringing the operating costs of brokers down. This will only accelerate as the financial sector adopts blockchain technology.
Trading commissions fell from over one percent 100 years ago, to a tenth of that by 2010. Zero commission is just the start. In the future, brokers may even pay their clients for the privilege of having their business. This may sound farfetched – but if a broker can make a profit without charging commission, why wouldn’t they pay to build a bigger client base?