Free Stock Trading, What's The Catch?

Investors can now trade stocks for free through a number of millennial-focused mobile platforms. The question is, how do these operations make money if they’re waiving commissions? A deep dive into these brokerage houses reveals a variety of business activities that build profits, sometimes to the detriment of their clientele.  As a result, potential customers should examine the fine print closely before funding commission-free accounts.

Free trading systems have come and gone in recent years, raising questions about the strategy’s viability. For example, Loyal3 shut its doors in 2017, transferring accounts to FolioFirst, which charges a monthly fee to its remaining customers. That revolutionary broker billed public companies directly for providing shares to their clientele and made IPOs available, bypassing industry practices that keep small investors from owning shares on the issue date. Sadly, the business failed after securing a very short list of equities, with just 66 participating companies.

Robinhood Financial has emerged as the category’s top player, offering both cash and margin accounts. The broker-dealer claims to stay afloat by earning interest on the uninvested portion of client funds while disclosure documents reveal other profit strategies, including margin lending, monthly fees for upgraded services and rehypothecation, which allows the company to use client securities as collateral for other financial activities. 

Rehypothecation occurs in a margin account when the broker-dealer uses an asset – stock securities in this case – as collateral to fulfill their own obligations or interests. In other words, they can fund their own market bets or borrow money from a bank, using your stocks as collateral if things go haywire. This practice may work well in quiet times but can have disastrous consequences when the financial system enters a crisis, as it did in 2008.

New customers default to margin accounts, potentially exposing them to rehypothecation, but they can be manually downgraded to cash accounts. Margin interest is waived on the standard account while the higher-tier Robinhood Gold charges a monthly fee, adding another profit source. They have fee schedules for all services not directly related to buying or selling stocks. Wire transfers cost $25 while overnight domestic check delivery costs $35. You’ll also pay for paper statements, transferring the account to another brokerage and telephone assisted trades.

The company routes trades through Dallas-based Apex Clearing, which utilizes payment for order flow practices similar to popular discount brokers, including E*Trade but it’s unclear if Robinhood benefits financially from that practice. They tell clients they’re getting the best available execution price but little detail is provided on how those orders are packaged. Given low market skill levels of their millennial clientele, most customers are probably placing market orders they expect to fill at the current price instead of limit orders that execute the requested price or better.

Robinhood is bound by SEC Regulation NMS, which requires customers to receive the “National Best Bid and Offer (NBBO).”  That promise may be harder to fulfill than it sounds, given the company’s terms and conditions, which state: “any price quotes may be delayed 20 minutes or longer.” Even small delays in the execution of market orders can generate self-serving opportunities to adversely impact quality and build profits for the brokerage.
They offer few frills and attract frequent customer service complaints, which are expected because ultra-thin margins generate a natural conflict of interest between customer needs and the company’s profitability. Even so, they’ve added features regularly in the last few years and have retained their enormous popularity. Many of these features come with price tags that add to profitability, including Robinhood Gold, which can incur monthly fees up to $200.

Mainstream brokerages including Charles Schwab and E*Trade offer free trading of exchange traded funds (ETFs). Both programs generate regularly updated fund lists that may exclude many popular choices, often at the expense of liquidity. This can translate into wider bid/ask spreads, with brokers making markets and pocketing the difference between buy and sell prices. Illiquidity can also discourage frequent trade execution although ETFs can provide excellent short-term term profit vehicles.

Free stock trading has evolved in recent years, with early business models often ending in closed doors. Robinhood now dominates this market niche, adding premium and fee-based features that compensate for the ultra-low margins of their commission-free business. Keep low expectations when using free trading platforms, expecting little handholding or customer service. Also be wary of trade execution price/quality because the broker has strong incentives for customers to pay more for stocks than real-time prices listed on national exchanges.