How commission-free trading could cost investors

The race toward zero commissions among discount brokerages is coming to a finish — and consumers could pay the price

How commission-free trading could cost investors

At first glance, the dominos-like dynamic developing among U.S. discount brokerages is a win for American investors. With commissions on trading in ETFs, U.S. stocks, and options being eliminated, it’s easy to imagine that users of such platforms will enjoy great benefits from lower costs.

However, as a quotation widely attributed to Milton Friedman (even though its use goes as far back as the 1930s) says, “There is no such thing as a free lunch.” The move toward zero-commissions could certainly be a win if one were to use ceteris paribus assumptions — that is, if all other factors were assumed not to change — but industry professionals are understandably skeptical.

One hand giveth, the other taketh away
The Tuesday afternoon announcement from Charles Schwab was followed by a broad decline in share prices of different brokerage firms. Analysts realized that eliminating commissions would severely hamper such companies’ returns and hurt their profit prospects.

That dials up the pressure on such trading-platform companies to find efficiencies or alternative sources of revenue. One outlook articulated by analysts, which was also shared by DataTrek Research co-founder Nicholas Colas, holds that the retail brokerage industry will undergo more consolidation.

“[R]etail brokerage firms will have to consider merging in order to maximize economies of scale,” Colas told ThinkAdvisor. What that means for investors using such platforms is less competition — not necessarily a positive in terms of cost and service.

Read also: Why industry's fee obsession is a "red herring"

Firms might also attempt to make up the lost revenue by more aggressively pushing in-house products or selling incremental services. There’s also the possibility of companies taking a cost-focused approach, reducing their expenses by cutting interest payments on cash balances in user accounts.

Investors, as well as advisors to trading-platform users, must likewise watch out for other company changes that could hurt the quality of the service provided. “It just got cheaper to do business at Schwab, but advisors must ask if the firm just got any better,” Allan Boomer, managing partner at New York-based Momentum Advisors, told “They recently announced layoffs, which may impact service. Also, they are doing a lot to re-shuffle their service teams and phone numbers; it's been a headache dealing with Schwab recently.”

Unseen pitfalls in trading
Eliminating the hurdle of trading commissions may also increase the chances of users falling into hidden trading pitfalls. As many professionals have contended, free trading encourages bad behaviour in the form of return-chasing, emotion-based investing, and underappreciated risk exposure, particularly among non-professional investors who decide to go it alone.

And according to Morningstar Global Director of ETF Research Ben Johnson, many large brokerage firms that stop charging commissions on trades may take orders from users and sell them to a third party to be executed on the users’ behalf.

“[T]he difference between the bid and the offer price that is around that price at which you execute, might not be as favourable … as if you had simply paid a commission and executed directly there with the broker that you're dealing with,” he said. “There's no way for your average investor to measure that. So that begins to disappear into the ether.”

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