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Fintech firms like SoFi and Robinhood offer “free” stock trading. What’s the catch?

March 1, 2019

Online lender Social Finance is rolling out a slew of new features, from commission-free brokerage to zero-fee exchange traded funds and crypto trading. But buying and selling securities, of course, is not free. So how does SoFi plan to make money?

One way startups can offer cut-rate prices is by burning through venture capital money, like Uber. For brokerage services, there’s also the Robinhood model, which makes money from interest on customer deposits, charging traders who buy stocks with borrowed money (margin), and selling clients’ stock orders to the market makers who handle the trades (payment for order flow).

San Francisco-based SoFi, which started out in student-loan refinancing, says it will lose money on brokerage in the short term. Its stock-trading business model resembles Robinhood’s: it will make money from interest on customer accounts, securities lending, and a small amount from payment for order flow. The company says it will publish detailed information about this soon. Over time, if all goes well, it may be able to convince customers attracted by its brokerage services to buy other higher-margin products.

Stock trading most certainly costs money, as shown by the ongoing skirmish over fees between exchanges, their customers, and regulators (paywall). The money simply has to come from somewhere. This matters because, at the very least, it’s annoying to switch brokerages if the one you use relies on an unsustainable business model.

“Commission free” can also mean that the actual cost is hidden somewhere else. Payment for order flow is a good example. Traders known as market makers post rapidly updated bids and offers, which is helpful for investors because it means there’s a ready market of up-to-date prices available when they want to buy or sell a stock. Some market makers (in the case of SoFi, a company called Apex decides which market maker gets the order) offer to buy retail-investor orders from the broker and execute the trades for them. Other brokers like TD Ameritrade and E*Trade do the same thing.

Market makers, sometimes called high-frequency traders, can save money by executing orders “off-exchange.” This means they avoid the fees that come with trading on New York Stock Exchange or Nasdaq by, for example, filling a retail stock order directly with their own money. In the US, market makers are required to provide the best bid or offer that’s publicly available, regardless of how a trade is filled.

Why would market makers want to buy a bunch of retail trades? The everyday investor is less informed and trades differently than the pros who, in theory, move in and out of assets more efficiently. Retail and institutional trades may flow in opposite directions, which is great for market makers who can provide bids to buy for one and offers to sell for the other. It’s also less risky: when trading on a public exchange, market makers have to compete with other sophisticated traders, as well as large investors who may buy or sell large chunks of shares, sending shockwaves through prices. A market maker that buys retail flow takes on less risk and should be able offer better prices as a result.

Imagine the spread between the bid and offer is three cents. That three cents is the profit a market maker expects to earn for fulfilling trades. If the market maker bought the retail orders from SoFi, it could hypothetically give one cent to SoFi and keep two cents for itself. SoFi can pass that money along to customers or keep it as income for itself. If SoFi keeps the money, that is essentially the cost of brokerage.

“Brokers face a choice—rebates for themselves or price improvement for their customers,” said Justin Schack, managing director at Rosenblatt Securities, an institutional brokerage in New York. “It’s obvious what’s in the customer’s best interest.”

Trading is a lot more complex than this simplified example, but you get the idea. Companies like SoFi and Robinhood that offer commission-free trading may offer a good deal for the customers. Likewise, there’s nothing wrong with SoFi, Robinhood, or Apex earning money by handling trades.

The thing is, “free” doesn’t quite explain what’s going on. These order-flow payments, according to former SEC chairwoman Mary Jo White in 2014, “can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed.”

The conflict comes when brokers don’t give customers the best possible deal for their trades, but instead go to the market maker who offers the highest payment for them. Brokers are legally required to give customers the best price, but White wasn’t so sure that they do. Others have similar worries: a class-action lawsuit filed against TD Ameritrade alleges the brokerage prioritized its profits (paywall) over retail traders’ best interests. The online broker disputed the claim.

In this behind-the-scenes back and forth, it can be difficult for the average investor to figure out what their broker costs, directly or indirectly. In the case of Robinhood, co-CEO Vlad Tenev has said the company earns roughly 2.6 cents for every $100 in stock that’s traded. To comparison shop, a trader needs to figure out the payment other brokers are earning from market makers and then see if that payment, and how much of it, is passed along. An analysis by the Wall Street Journal (paywall) suggests that Robinhood may be more expensive than its rivals.

SoFi’s new “commission-free” brokerage may turn out to be a great deal for investors. But it’s certainly not free.

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