Market Notes

Eagle, CO

How much does “free” cost?

It’s more than zero, I can assure you. Most people know that when something is free it is often they (or their personal data) who are for sale.

Last week, the big online brokerage firms cut their trading fees for most securities to $0. First-level thinkers might celebrate this as freedom to trade more frequently with smaller size thus reducing risk.

Second-level thinkers might wonder how the business plans to make any money and suspect that something is amiss.

Both would be correct. There are pros and cons – as with anything else.

Folks may have the same feelings about things like Facebook, too. If it is free to the user but the company is selling the user’s private data to the highest bidder – how much is it really costing society in the aggregate?

Or if you are an advertiser, can you argue that the market for private data it is a net-benefit? I know I have purchased products that I learned about for the first time from my Facebook feed. And we consumers are 70% of the domestic economy, right?

To be really clear – nothing is free. But sometimes costs are really difficult to quantify. And this note isn’t meant to pick on any particular firm – but rather to educate folks on what is really going on.

Let me catch you up if you weren’t following along over the past week or so.

On Thursday, September 26 Interactive Brokers (where we have plenty of accounts) announced a new type of account agreement for smaller investors called “IBKR Lite” which provides unlimited commission-free trades on US exchange-listed stocks and ETFs.  In a radical departure from historical operating procedure Interactive Brokers (IB) would pay for this service by selling the trade order flow to execution services like Citadel and Virtu.

The other big online brokers quickly followed suit reducing their commissions to zero for most trades, within the week of IB’s announcement.

Now, if you are unfamiliar with payment for order flow, I encourage you to check out the book Flash Boys by Michael Lewis. In short form, firms like Citadel and Virtu pay brokerages like TD Ameritrade and E-Trade for the ability to execute client orders on behalf of the brokerage. These high-frequency trading firms then know which trades investors want to make ahead of the trades being executed in the market, and essentially trade right in front of the clients hundreds of thousands of times every day. They very rarely lose money on any of these transactions.

Seems illegal right? Well, its not. These high-frequency trading firms provide valuable liquidity to the markets and given that fact, the regulators essentially allow the practice. The SEC does however mandate that firms disclose information related to payment for order flow in quarterly reports called “Rule 606 Disclosures”.

Interactive Brokers (IB) had traditionally been the low-cost custodian for the active trader, but never ever sold trades to execution service firms. Rather, IB simply routes customer orders directly to the best exchange.  With the new announcement, the only way to pay for the cost of trading will be to sell the orders for those clients under that agreement to firms like Citadel. To be clear, most accounts will still be treated the way they have been – with cost of $0.005 per share traded and smart routing direct to exchanges.

All the other big firms (that I am aware of) have always charged commissions and then sold the order flow to execution firms and reaped huge benefits for it.

For example, around 1.8 trillion shares of equity traded last year across all exchanges. I believe this does not included ETFs, but it may. It is sort of hard information to find. But either way, according to the Rule 606 disclosures I have reviewed, payments range from $0.0009 to $0.0030 per share. I cant seem to find much data on how many shares of the 1.8T were traded at each firm (I am still digging) but if all the online brokers collectively accepted 10% of the trades placed (which I think is conservative), they shared around $270,000,000 of revenue in 2018 selling client orders, using an average price of $0.0015/share.

That is actually just one reason that these firms can afford allow you to trade for “free”.

Check out the reports for yourself by googling “rule 606” and your chosen broker’s name. Or see below a few of the biggest firms (including those we recommend to our clients, IB and Schwab):

·         Charles Schwab Rule 606 Disclosure Q2 2019


Ben Hunt has been writing about commissions at brokerage firms for a while. I don’t really know what his position on all of this is, but he is a profound thinker and writer. I encourage you to follow him on twitter and check out his recent post on brokerage fees here.

So, as I said before, it is sort of hard to quantify just how much money is being made in the aggregate from brokerage firms selling their customer orders to high-frequency trading firms – but there is some anecdotal evidence that the financial services industry is doing better than the average investor.

For example, it was recently reported (Sep 10, 2019) that Ken Griffin, the CEO of Citadel, purchased a new mansion in Palm Beach, FL for $99 million. You can just add that to collection of real estate that already includes the most expensive home in America, which he bought back in January 2019 for $238 Million.

Seems like the arrangement is working okay for the financial guys – I suppose it’s about time they started sharing with the rest of us!

Here is the thing… there is another really sneaky way these firms are making money. In the interest of your time, I will save that for the next blog. But, for now – just know that even though you see shares of AAPL on your statement – they may not actually be in your account! Sort of like the dollars in your bank account…

Before I go, please join me in congratulating Mr. Jacob Going who has earned the new title of Director of Investment Operations. This new title more accurately reflects his daily contribution to the firm and is very well deserved.

Thanks for reading!

Shane Fleury, CFA

Chief Investment Officer

Elevate Capital & Elevate Ventures



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