The Downsides to Zero-Cost Commission

This week, financial services firm Charles Schwab announced that they would be eliminating trading commissions for stocks, ETFs, and options listed on U.S. or Canadian exchanges for clients using mobile or web applications. Though the press release stated the motive was to lower barriers for investors, it was likely done in response to initiatives from other e-brokerage firms – like Robinhood and Interactive Brokers – who also offer commission-free trading. In fact, Interactive Brokers announced a commission-free service would begin in October, and TD Ameritrade followed suit hours after Charles Schwab.

While we have discussed in the past why the appearance of zero-cost commissions are misleading for retail investors, we will also discuss whether the trend towards zero-cost trading commissions and the internalization of order flow is considered “best execution” for the market as a whole. What might not be clear to some investors is that brokerage firms in the U.S. are able to sell order flow to dealers in a non-competitive/non-transparent process, generating fee revenue on what is otherwise dubbed as “zero-cost commission” order flow. In Canada, it’s not exactly the same process; certain exchanges will provide rebates to passive broker flow while charging liquidity-taking active participants to trade against this order flow, effectively achieving the same thing. The difference is that in the U.S. the dealer paying for the order flow can internalize the orders and take the other side without the order flow hitting an exchange, which could lead to having the change to transact against other market makers that could promote greater competition and thus overall market liquidity. Though, retail brokers that are selling client flow may argue that the combination of reducing trading commissions and showing some price improvement on an order-by-order basis is a net benefit to the client, the concern is that it reduces independent competition that could lead to the degradation of market structure.

Furthermore, it is worrisome that much like in the asset management business where economies of scale allow AUM to grow through additional fee reductions, larger liquidity providers can increasingly shut out independent market makers as size leads to more opportunities for internalization. While we are usually proponents of initiatives that reduce fees and costs for investors, the end result of execution costs trending toward what is mistook as “zero” may not ultimately be beneficial for the marketplace as a whole.