While Charles Schwab, TD Ameritrade and E*Trade are focusing on the marketing element of their race to zero commissions, consumer advocates are warning investors about how freebie trading could hurt them and questioning if regulators are paying close enough attention.

All three brokerages last week eliminated commissions on online trades of U.S.-listed stocks, ETFs and options, as reported. For Charles Schwab and TD Ameritrade, commissions are also eliminated on stocks, ETFs and options listed on Canadian exchanges.

Consumer advocates are raising questions about how the price wars might ultimately impact retail investors, particularly in terms of the hidden costs they might have to bear and how they could adversely change their investing habits.

They also question whether there is enough regulatory muscle to police the potential impact of the price wars on retail investors.

Micah Hauptman, financial services counsel for the Consumer Federation of America, notes that all three brokerages are for-profit companies, so they will try to make up for the revenue they lose from the commissions by other means.

Routing orders to the venue that pays the most raises best execution compliance questions.
Micah Hauptman
Consumer Federation of America

Charles Schwab's chief financial officer Peter Crawford says the firm’s business model “doesn’t depend on commission revenue.” He quantified the impact of the zero commissions on the firm by estimating the lost commissions would be equal to around $90 million to $100 million in quarterly revenue, or around 3% to 4% of net revenue.

The expected impact of lost commissions is greater for TD Ameritrade. The firm’s CFO, Steve Boyle, says they would be equal to around $220 million to $240 million in quarterly revenue, or around 15% to 16% of net revenue.

Hauptman says the big question on his mind is how the three brokerages will make up for those lost revenues.

“I’m concerned retail brokers may replace the direct and transparent approach of charging commissions with indirect and opaque charging. That could result in investors still having to pay these or other costs in ways that aren’t readily apparent or subject to market forces,” Hauptman says.

For example, Hauptman notes that retail brokers execute retail orders using OTC market makers or high frequency traders who pay the retail brokers for order flow.

How zero commissions could impact best execution

Hauptman is referring to the practice of trading firms buying the retail investor orders from brokerages and executing the trades for them.

These trading firms earn from differences in bid and offer prices, and they share some of those earnings — in the form of rebates — to the brokerages that provide the orders.

“Routing orders to the venue that pays the most raises questions about whether the retail broker is complying with its best execution obligations,” Hauptman says.

“Given that the SEC and Finra have taken a hands-off approach with regard to order routing conflicts, I think it’s reasonable to expect that these retail brokers will continue this practice and could exacerbate it,” he adds.

Trading at zero expense could also incentivize retail investors to trade more, without regard to consequences, according to Hauptman.

“First, excessive trading can significantly reduce returns. Second, excessive trading can create taxable events — to the extent the trading is occurring in a taxable account,” he says. “More trading is good for the OTC market makers but it is unlikely to be good for investors.”

Tyler Gellasch

Tyler Gellasch, executive director of the Healthy Markets Association, underscores the reality that online brokerages will have to get paid from other sources to keep the lights on.

Healthy Markets is an investor-focused group that aims to educate market participants and promote data-driven reforms.

“By zeroing out commissions from their retail customers, the brokers are going to be increasingly dependent on other revenues, most likely payments for order flow,” Gellasch says.

"The explicit commissions may go down, but the overall trading costs from customers definitely become less transparent, and perhaps even higher,” he adds.

Gellasch recalls Senate hearings in 2014 about how brokers were maximizing their profits instead of getting their customers the best prices.

“Most regulatory observers thought the days of payment for order flow were numbered,” he says. “We were wrong."

Gellasch says the SEC and Finra have rules that require brokers to seek the best execution for their customers, “which typically means the best prices in the retail context, but regulators have done very little to enforce those rules.”

The Robinhood effect

Gellasch also notes that some regulatory observers thought the disruption caused by Silicon Valley startup Robinhood Financial would lead to reform in transparency of costs.

Robinhood, a Finra-registered broker-dealer since 2013, has been providing free trades on U.S.-listed stocks on its smartphone app since its launch.

"A year ago, the question was whether regulators would let Robinhood’s business model exist, given its lack of transparency into costs. Today, the question is which brokers won’t adopt that model,” Gellasch says.

“This change will not just impact the retail traders, but it will likely impact where securities trade, who trades them, and the cost of trading across the entire market,” he adds.

Best execution was among the market risks Finra highlighted in its 2019 Risk Monitoring and Examination Priorities Letter published in January.

“Finra is concerned about firms failing to use reasonable diligence to assure that their customer order flow is directed to the best market given the size and types of transactions, the terms and conditions of orders and other factors,” Finra says in the letter.

“In particular, Finra will review firms’ best execution decision-making where the firm routed all or substantially all customer orders to a small number of wholesale market makers from which they received payment for order flow or an affiliated broker-dealer or an alternative trading system in which the firm had a financial interest,” the SRO adds.