“Fee-free options trades!” “No commission trading!”
Music to the retail trader’s ears, right?
At least, if you knew the true cost of “fee-free trading,” you might not be so quick to hop on the “commission-free brokerage” bandwagon.
Whether you realize it or not, your fee-free trading platform has a higher cost than you think.
Are you getting swindled? We’ll take a look right here.
The Hidden Costs Of “Fee-Free” Trading
If you’re not paying for it … you’re not the customer. You’re the product being sold.
Or rather … your trades are.
It’s called “payment for order flow” (PFOF) and it’s costing you money.
How does it work?
When you send your trade through one of the many free brokerage platforms now available on the market, your trade doesn’t hit the market right away …
Rather, your fee-free brokerage re-routes your order to a wholesale (typically off-exchange) market maker, such as Citadel Securities, Susquehanna, or Wolverine, who then pays your broker for the order flow sent their way.
What’s the problem here?
It means your trade is going to the market maker of your broker’s choosing … regardless of whether or not it will actually get you the best price on your trade.
The broker and market maker are able to view your trade before it’s executed, and market makers can arbitrage their buying and selling prices (called “internalization”).
There’s also the potential for market makers to make the same trade themselves before filling your order. This gives them an unfair advantage, and may lead to even bigger unfairness in the marketplace, creating yet another advantage that “Big Money” has over the rest of us.
Not only do market makers get an unfair advantage, but there’s no guarantee you’re getting the most favorable execution. In fact, you’re probably not.
So you’re “paying” for every trade you make, whether you know it or not!
In exchange, your broker gets a kickback, and the market maker is able to profit off of the increased trading volume they’re receiving (remember, market makers profit off bid-ask spreads, and the more orders they fill, the more they’re making).
The practice was pioneered by Bernie Madoff – yes, that Bernie Madoff – which should give you an idea about the ethical backings of the practice …
Brokerages such as Robinhood (Ticker: HOOD) argue that PFOF don’t hurt customers …
But given that Robinhood makes a substantial portion of its revenue (about 80% in the first half of 2021, which amounts to $185 million for equity order flow, and a whopping $600 million for options flow) from PFOF payments, their opinion on the matter may not be entirely objective …
I’d also like to mention that HOOD paid a $65 million SEC fine related to PFOF last year, though the firm didn’t technically admit to any wrongdoing …
And merely the mention of a PFOF ban sent the shares skidding on Tuesday morning …
But the practice has been around for decades …
So why do we care about PFOF all of the sudden?
PFOF has been making headlines this week after the Securities and Exchange Commission (SEC) chair spoke out, saying a PFOF ban is “on the table.”
HOOD shares slid on the news, and Robinhood’s chief legal officer struck back, saying the idea of a PFOF ban is “draconian.”
Personally, I’m all for it, and the practice has already been banned in places like Canada and the U.K.
If PFOF is successfully banned, it could have a number of consequences, and structurally change the entire trading business … to the benefit of the customer.
First, your trades will directly hit the open market, giving you more favorable pricing.
It will also make markets significantly more transparent.
Stock exchanges that are built on PFOF will collapse, and we’ll likely end up going back to just a handful of exchanges – but maintaining our current volume of trading, which will tighten up markets.
But do I actually think PFOF will be banned?
It’s hard to say. The SEC has examined the practice before, but obviously didn’t end it.
This time around, it does seem like PFOF could actually come under real scrutiny.
If I see a solid indicator that it could actually be banned, I’m already watching a handful of stocks I could go long on …
IntercontinentalExchange Group (Ticker: ICE): ICE operates a number of global exchanges, including the NYSE. If PFOF is banned, this ticker could see some solid upside as order flow flows back to open markets.
Nasdaq OMX Group (Ticker: NDAQ): NDAQ operates global exchanges … most notably, as you can probably guess, the Nasdaq. They’d be another beneficiary of the increased open-market order flow.
CBOE Global Markets (Ticker: CBOE): My personal favorite (not like I’m biased or anything …). The CBOE operates — wait for it — the CBOE (Chicago Board of Options Exchange).
While Robinhood — among other big name exchanges — will undoubtedly fight any PFOF restrictions being put into place, much less an elimination of the practice altogether, I believe any amount of regulation would only serve the customers — like you and I.
Your Only Option,