There is no such thing as a free lunch so when a company claims to offer something at zero cost there is always a catch. In the case of discount “free trading” brokerages, the user is often paying for the service through higher fees elsewhere.
Robinhood: The Customer Isn’t Really The Customer
Robinhood gained notoriety as one of the first discount brokers to challenge the status quo that investing in stocks is reserved for the wealthier segment of the population. The company offers stock trading and other services to its users at zero cost. Now, the obvious question observers need to ask themselves is how can a company operate by giving away their service for free.
We know the answer. Robinhood has a unique business model that is quite complex and differs from its rival online stock brokers.
Simply put, Robinhood acts as a sort of middleman by accepting customer orders and sending the orders to high-frequency traders and hedge funds. This practice is legal and has a name within the online stock broker universe: payment for order flow.
Supporters of the practice argue that Robinhood’s close connections to high-frequency traders mean it can get a better price compared to sending the order to the New York Stock Exchange. According to a 2018 report from The Wall Street Journal, it wasn’t clear if Robinhood was passing along the benefit to the customer.
WSJ notes that a theoretical order to buy 100 shares of Apple at $200 a share would net Robinhood a cut of $5.20 for routing the order to a firm, like Citadel Securities. By contrast, legacy online stock brokers like Schwab would collect nine cents for completing the same order.
This is like receiving a free Big Mac at McDonald’s but paying $6 for the fries and drink when a traditional combo costs $5.75. Sure, the Big Mac was technically free but the consumer is getting a worse deal.
In 2019 Robinhood paid the US Securities and Exchange Commission $1.25 million to settle regulatory claims it didn’t ensure clients received the best possible price for orders. While the company claimed at the time it took steps to improve its execution and processes, the fact remains clear: Robinhood’s user base is not the firm’s client, rather it is the product, and firms like Citadel are its real clients.
This Canadian ‘Free’ Discount Broker Has A Catch
Wealthsimple is one of the Canadian online stock brokers looking to challenge discount brokers that banks operate through unique offerings. Wealthsimple is known for its robo-advisory service in which customers take advantage of curated investment options based on their unique and individual circumstances.
In this case, Wealthsimple offers zero-commission transactions in exchange for a fee equal to 0.5% of assets under management. The fee drops to 0.4% for clients with more than $100,000 in their accounts.
A customer with a $25,000 portfolio will pay $125 a year in fees. This might be an ideal scenario for young people who are new to investing and don’t know (or want to know) how to properly manage their savings. But savvy investors that are comfortable in setting up their portfolio and willing to monitor it are paying much more for “free” trades with Wealthsimple.
Wealthsimple also offers a do-it-yourself option for investors that want to manage their own portfolio. Unlike every other Canadian discount broker, The online broker does not allow customers to hold US dollars in their account. So each time they sell a US dollar-denominated stock it is automatically converted to Canadian dollars. If they want to reinvest the proceeds from a stock sale in another US stock they need to unnecessarily pay another exchange rate markup.
Do ‘Free’ Discount Brokers Fuel Volatility?
Free and very cheap online brokers introduced tens of millions of new investors to the market. Robinhood alone added 13 million new users in 2020, many of which followed the lead of Barstool Sports founder Dave Portnoy who live-streamed his trading during the early days of the COVID-19 pandemic.
Portnoy started trading with zero experience and minimal knowledge of stocks. But his vast business acumen eventually translated to profitable trades after some initial losses. His charismatic personality fueled his popularity and made it clear to millions of new people they can also profit from stocks whether they are investing $100 or $1 million.
The GameStop and other “meme stocks” fiasco of early 2021 made it abundantly clear that investors and traders on free online stock brokers can move stocks in ways that have never been seen before.
The Wall Street Journal notes that the surge in average investors using discount online brokers is collectively large enough to create a “power shift” on Wall Street. The power shift was evident when a hedge fund powerhouse Melvin Capital Management was on the losing side of the GameStop trade by the tune of billions of dollars.
Bottom Line: Free Isn’t Free, But It Can Still Be Worth It
Before Robinhood and other “free” discount brokers came along, the average person felt left out of the stock market surge. There is some validity to this thesis as Robinhood was among the first to offer fractional share ownership at no upfront cost to an investor.
Canadian online stock broker Wealthsimple offered a similar proposition of giving smaller investors access to professionally managed investment products. Granted, its zero-fee platform could end up being more expensive than standard discount brokers that offer a fixed fee per transition.
But for many investors “free” is a fantastic option.