As the rise of self-directed retail investing increases with technological innovations and fintech, investors should remain increasingly critical of how their brokers are making their money. The saying, “If you’re not paying for the product, then you are the product” is as relevant as it has ever been in the age of commission free trading.
In Canada the most prominent commission-free brokerage is Wealth Simple, whereas traditional brokers such as CIBC’s Investors Edge or BMO’s Investorline charge fees beginning at around six dollars. Given that Wealth Simple’s primary line of business is brokering deals between buyers and sellers, it is only natural to question how their revenue is made if they charge no brokerage commission. The company maintains that their only source of revenue is a conversion fee of 1.5 per cent applied to all USD orders, and that they do not sell order flow to high frequency trading firms.
Robinhood – the popular commission free broker platform in the U.S. – has been in hot water for doing exactly what Wealth Simple claims to have never done: selling the order flows of its customers to the highest bidder, and profiting from the bid-ask spread leads to the direct detriment of their users’ pecuniary interests.
A bid-ask spread is the difference between the prices quoted for an immediate sale and an immediate purchase for stocks, futures contracts, options or currencies. Without being overly technical, profiting from the bid-ask spread requires the broker to sell the right to execute its users’ trade to another broker. In essence, allegations against Robinhood suggest that the broker is able to forego the typical commission fee by sourcing its revenue through other means – means that are potentially more costly to investors in the long-run. Regardless of whether the costs of this strategy are cheaper or more expensive for investors, they are still misleading. Notably, the Securities and Exchange Commission has fined Robinhood $65 million for misleading customers about how the platform makes its money. The fine is civil, and the company has not admitted to any wrongdoing.
It is certainly possible that models like Robinhood’s may be cheaper for investors. A Bloomberg report suggests that the bulk of Robinhood orders is bought by Citadel Securities, a high frequency trading firm, and on average Citadel pays less than $0.0024 per share. This is an amount unlikely to ever be noticed by investors on a per trade basis. In aggregate however, it has the potential to be costly. The SEC suggests that Robinhood’s inferior trade prices cost customers $34.1 million, even after considering the savings from not paying a commission. Trading volume on Robinhood is incredibly high, and the SEC filing reveals that it is not unusual for Robinhood to make around $180 million in payments for trades in a single quarter.
Aside from profiting from bid-ask spreads, Robinhood has been sued for its role in “gamifying” investing. The Massachusetts lawsuit claims that Robinhood uses aggressive tactics to attract new and often inexperienced investors, employs strategies to encourage and entice continuous and repetitive use of its trading application, and also fails to follow its own procedures regarding the approval of options trading. The suit highlights that at least 670 users with limited investment experience averaged at least five trades per day. One particularly egregious example involves one customer who executed more than 12,700 trades in just over six months.
While Canada has not yet witnessed similar drama as the U.S. has with Robinhood, the lesson for Canadians is clear: investors must remain critical and weary of their brokers in this new age of investing. While the democratization and increasing accessibility to the markets is good for the average person, there are reasons to be cautious.
