Gil’s Musings

Free Trades? They’ll Still Get Paid

When I was just a kid, my dad showed me how to catch a Chameleon lizard with my hands. The technique is to slowly wiggle your fingers closer and closer to the lizard’s face. He will likely be so mesmerized by the immediate threat and his defensive posture, he won’t see your other hand sneak up behind him and grab him by the neck. So it is with free commissions in the brokerage world. Schwab announced today that stock trading will be free, and option trading will be mostly free starting on October 7th. But just like everything else in life, nothing is really free, you just pay for it in different ways.

The brokerages do have limited venues to make money, and they’re pretty defined. The majority of Schwab’s revenue comes from interest earned on client idle cash. The second most valuable income stream comes from interest earned on margin loans. The third is payment for order flow. Order flow is the valuable commodity that can be viewed much like a lubricant. The trading machines work better when they don’t sit idle and so big brokerages like UBS value this lubrication so much that they’re willing to pay firms like Schwab to execute their trades for them. The brokerages also make money from rapid-fire traders who pay for brief glimpses of client orders prior to execution. That last one is a moral minefield that I have complained about for years. However, I softened my opposition to it when I realized that orders go off at no worse price than the bid or offer side, and it generally allows only a fractional cent profit for that trader. It’s really no worse than a market maker who has existed since the beginning of financial time, and back in the day, that specialist might earn the entire 1/8 of a dollar (12.5c) inside the spread between bid and ask price. Spreads are now mostly a penny or less, which means the objectionable fractional cent spread is far less than the 12.5c we previously paid for decades, and the tightening of those spreads is good for clients and is attributable to order flow. I may grumble, but it does have some positive attributes for clients. I primarily object on moral grounds that clients should own their information until their order exits the pipe in public view.

So while the marketplace is demanding commission free trades, you can expect more aggressive brokerage moves to earn more on any investor’s idle cash. You can also expect a little more rigidity on negotiated margin rates for loans. So our job comes down to that of the pivoting eyeballs of the lizard, which can see the second hand sneaking up from behind. At least I have a little advance intuition that the hand is coming.

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