trading-stocks

No commission trading – is there a price to it?

Alvin Chow
Alvin Chow

Robinhood caused a stir in the trading community, especially among the millennials, when they introduced zero commission trading in 2013.

Trading commissions have been declining for many years but zero was a big thing – nothing beats free.

To top that off, Robinhood’s app features a sleek design and good user experience that even Apple would approve of.

It’s packaged to speak to the current generation, as Morgan Housel puts across nicely,

One reason is that it’s hard to feel like you’re moving ahead in life when you associate with your parents’ brands. Every generation wants their own stuff. The odds of getting a 16 year old hooked on Seinfeld or Alanis Morissette round to zero – they are social hand-me-downs. Morgan Stanley could make the indisputably best robo advisor and millennials would still prefer Betterment. That’s how Charles Schwab blossomed in the 1980s and 1990s; with a brand baby boomers felt was theirs, not their parents’. Robinhood is now filling that spot for Gen Z. It does few things the older brokers don’t already do, and it’s constantly breaking down. But young investors love it because it’s theirs.

People will judge you based on the broker you use – Robinhood is cool. Schwab isn’t.

Maybe Singaporeans cant relate because Robinhood isn’t available in Singapore while Charles Schwab had closed its office here in 2019, just after 2 years of operations.

But now, we have Interactive Brokers on which you can buy US-listed ETFs without commissions!

And I believe more of such options would be available to us eventually.

Can this really be a free lunch?

How do they make money?

It takes a book to explain how money is made in a commission-free trading service – Michael Lewis published Flash Boys in 2014 and expose the world to the dark pools.

You probably heard of High Frequency Trading (HFT) where trades are done faster than you can blink your eyes. This can only be done by machines and are impossible for human traders.

Lewis’ story starts from a company that dug a tunnel and laid cables to connect to the security exchanges, so as to reduce lag. Every second counts for HFT programs. It costs millions to set up, this company then sells the access to financial institutions.

Essentially, they need to be faster than others in order to front run the orders to the exchanges. They then arbitrage the price differences between private exchanges and official exchanges. These private exchanges are known as ‘dark pools’.

Imagine that you placed an order to buy a stock at $1.00. Your order get routed to the dark pool instead of the exchange that you thought you were sending it to. A HFT firm sends false orders of $0.99 to the official exchange and gets filled. The firm then passes you the stock and collects $1 from you. It has pockets the $0.01 difference. All these are done in microseconds and without your knowledge.

The broker didn’t charge you a fee because it has been paid by the HFT firm who ‘bought’ your order.

Essentially, a broker that offers free commission trading can make money by selling the order flow of its clients to the HFT firms.

The consequence as you can see is that you end up paying more and selling for less.

But the spread is so minor, most people do not bother…unless you buy or sell at high frequency or if you’re investing a sizeable amount of money.

Some investors however, find this unfair and are worried about the lack of transparency. They no longer trust prices from the exchange prices, since these prices could be faked by HFT firms.

Fair point because transparency is important in the markets. Transparency breeds trust and in turn, trust enables transactions to happen.

Fighting back

Brad Katsuyama is the protagonist in Flash Boys. He created a new securities exchange to level the playing field. His solution was a simple, elegant one – he added coils of wires just before the exchange servers to slow down the HFT firms. He called it the Investors Exchange (IEX) – the closest thing to socialism in the capital markets.

Just a day ago (at the time or writing), the Securities and Exchange Commission (SEC) is investigating Robinhood, on its disclosures regarding their practice for selling customer orders to HFT firms.

They face a fine of more than US$10m. This is a non-issue considering that it has raised US$520m in the last two months.

Where are we going from here?

Trading commissions are falling, I wrote about it here. And I think free trading will arrive eventually.

Selling order flows would just become the new norm that investors would accustom to. For example, people know that they are being sold to advertisers on Facebook and yet they are still happily using it. Similarly, although investors may know that their orders are sold to HFT firms but because they don’t feel shortchanged, at least not in an obvious manner, they won’t be upset about it.

I think the exception could be investors with higher capital. A minor spread can mean a lot of money. I would think that such players would prefer to pay the obvious commission costs than hidden spreads.

That’s what I think. Are you for or against zero commission trading?

Alvin Chow
Alvin Chow
CEO of Dr Wealth. Built a business to empower DIY investors to make better investments. A believer of the Factor-based Investing approach and runs a Multi-Factor Portfolio that taps on the Value, Size, and Profitability Factors. Conducts the flagship Intelligent Investor Immersive program under Dr Wealth. An author of Secrets of Singapore Trading Gurus and Singapore Permanent Portfolio. Featured on various media such as MoneyFM 89.3, Kiss92, Straits Times and Lianhe Zaobao. Given talks at events organised by SGX, DBS, CPF and many others.
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