Most retail securities brokerages now offer commission free trading. However, I elect to use a brokerage platform that still charges commissions (IBKR PRO). And furthermore, I cover my clients’ commissions directly out of my portfolio management fee. Why do I do this when there are free options available?
Why do I pay comissions?
In short, I elect to pay commissions in a largely commission-less retail brokerage world because that’s what’s best for my clients. The IBKR PRO platform I use to trade is geared towards professional traders. Pros are willing to pay small commissions for the opportunity to access a wider array of execution possibilities. This ensures that my client’s and I can get the absolute best possible execution on all trades.
Free trading isn’t really free
Like anything else, if you are getting securities brokerage services for free, you should ask how your service provider is actually making money. Free brokers actually make money by “payments for order flow” from other trading firms. These payments for order flow are essentially legal bribes. A trading counterparty pays a stock broker to route trade execution to them preferentially over other counterparties. So you get a free trade, the broker gets a small payment, and the counterparty gets a trade that they otherwise wouldn’t have gotten.
Isn’t my broker supposed to give me “best execution”
Stock brokers are generally required to give their clients “best execution” on client order flow. On its face, this rule seems to preclude payments for order flow. The payment should only make sense for the payee if their execution price is not the best. However, in practice, brokers can reasonably claim best execution for paid order flow fairly easily. The trick for discount brokers to be able to claim best execution, without actually providing it, is to ignore dark pools.
The public order book
Historically, the main way to buy and sell stocks has been on the New York Stock Exchange (NYSE). The NYSE has a public order book. For any given stock, the public order book might say something like “There are 100 shares available to buy at $10.50 and another 200 shares available to buy at $10.55. There is an offer to buy 50 shares at $10.00 and a second level offer to buy another 100 shares at $9.90.” In this example, the public “bid-ask” would be $10.00 – $10.50. The best public price you can buy a share at is $10.50, and the best public price you can sell a share at is $10.00.
In this situation, if you place a BUY MARKET order, and the discount broker executes your buy at $10.50, they can reasonably claim they achieved best execution. However, in modern times, there is a LOT of trading activity outside of the NYSE and Nasdaq. In fact, non traditional trading hubs, called dark pools, now represent 40% to 50% of US equity trading.
What are dark pools?
Dark pools sound scary but really they are just other ways for parties that want to trade stocks to meet each other, talk pricing, and execute trades. The key difference from the public exchanges is that players don’t have to publicly post the prices at which they are willing to execute trades. A large asset manager who controls a multi billion dollar retirement fund might not want to publicly state that they have a large order to work. That knowledge might affect the market before their trade executes. Dark pools allow players to expose themselves to trade opportunities without publishing their “book”.
What do dark pools mean for best execution?
This is where best execution comes in. In our earlier example, according to the NYSE, the best possible price to buy the stock was $10.50. The best possible price to sell the security was $10.00. But, that’s based on the public NYSE order book, and doesn’t account for players in the dark pools. They might be willing to trade at even better prices, but just aren’t publishing that fact. So, for example, if I go to a dark pool, I might be able to buy the security at $10.35. In other words, I haven’t really found true best execution until I check the dark pools.
How IBKR PRO gets better execution than best execution
The IBKR algorithm I use helps me access the better pricing available in dark pools. When I work a trade for my clients, I don’t just accept the best current offer price on the NYSE. I use the IBKR algorithm to progressively scan all liquidity sources, including dark pools. So, in our example, the algorithm might initially transmit a willingness to buy the security at $10.00 (instead of $10.50). This probably won’t get executed. But then the algorithm might rapidly scan out different values, increasing progressively up to $10.50. Most likely, for a liquid security, it will find a matching order in a dark pool somewhere around $10.35 to $10.45. So we beat “best execution” by $0.05 to $0.15! This doesn’t seem like a big deal, but it’s very important for me to really grab every advantage possible for my clients.
One more way the industry is shady
This is all pretty scammy. All of these discount brokerages know about this part of the stock market. Free brokerages use the no-commission model to attract less sophisticated investors. Then they accept bribes from traders to direct order flow to those traders. The traders then get to execute trades at favorable pricing, because the discount brokers don’t allow their clients the benefit of dark pool liquidity. The counterparty traders pay a fee to the broker, but they get it paid back and then some by getting favorable trade pricing. The big loser is the investor that thinks they are getting something for free!
I do this the right way, doing everything possible to get true best execution. I’m not satisfied with “good enough for the regulators” execution. And just to make sure that my clients’ needs come first, I pay the commissions out of my end. They aren’t very big and I’m proud to be able to operate in a way that very obviously puts my clients first.
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