The real costs of commission-free trading

US broker Robinhood brands itself as the pioneer of commission-free trading, having offered this to customers in the US since 2015. The broker said in November last year that it would launch in the UK this year. But it has now said the launch has been postponed indefinitely.

Robinhood has been criticised for gamifying investing and luring young traders to take on inappropriate risk, sometimes with devastating consequences. 

The most high-profile example of this was when last month Alex Kearns, a 20-year-old user of Robinhood in the US, committed suicide because he wrongly thought that he was $730,000 (£577,000) in debt due to his trades in options. 

Other brokers already offer commission-free trading in the UK. These app-based dealing platforms aim to make investing accessible, for example, by offering fractional trading – the option of buying less than one whole share in a company. This is useful for traders who want to deal in very expensive stocks such as US tech companies, of which the price can be very high. For example Amazon's (US:AMZN) share price was over $3,000 as of 20 July.

Many private investor platforms in the US offer fractional share trading, but it is not offered by any of the large traditional UK platforms. So the commission-free trading platforms that offer this are particularly popular with young investors who have less money to invest.

Some commission-free platforms let their users trade contracts for difference (CFDs) as well as stocks. CFDs are a form of derivative trading that allow you to speculate on price movements in securities such as shares, treasuries (US government bonds), currencies and commodities. With these, instead of buying a share or a unit in an asset, you agree with another party to exchange the value of a security’s price movement, sometimes by borrowing money to amplify any gains or losses. Brokers make money on the spread – the difference between the buying and selling price – of CFDs, even if they do not charge a dealing fee. 

As trading incurs administrative expenses for brokers, if they offer the service commission-free they will look to cover the costs by generating revenue in other ways. “There’s no such thing as free – particularly in financial services,” says Mike Barrett, director at platform consultancy the Lang Cat.

Freetrade and Revolut, for example, are looking to generate revenue via a Netflix-style subscription model. Although commission-free trading is one of the options they offer, their aim is for increasing numbers of customers to sign up to a more comprehensive and expensive service. They can also make money by investing cash in their customers’ accounts in money markets, while Freetrade levies a 0.45 per cent foreign exchange charge.

However, while both these platforms have seen rapid growth in their number of customers, neither looks close to profitability. Even so, they have received healthy cash injections from venture capital investors this year. 

A large a number of Trading 212’s and eToro’s customers, meanwhile, trade CFDs so their main source of revenue is the spreads and interest swaps on these products. But as CFDs are risky, regulators have introduced restrictions on the amount people can borrow when trading them, to protect customers. Regulations have also forced these platforms to disclose that three-quarters of their customers have lost money when trading CFDs. 

Trading 212 said in June that its immediate goal is to grow its customer numbers with free stock trading, but it plans to move to a “subscription-based or fremium model” in the medium term to generate revenue down the line. A “fremium” model is when users get the basic features of a service for free and pay for upgrades to the basic package.

So before trading via a commission-free platform, make sure you understand its business model.

No free lunch

Commission-free platforms tend to offer far fewer stocks than traditional ones and none currently offers funds. Platforms such as Hargreaves Lansdown, AJ Bell, and interactive investor offer all shares and exchange traded funds (ETFs) that have their main listing on exchanges they provide access to, as long as they meet regulatory requirements. However, the number of securities available to trade via commission-free platforms is growing.

Due to their lower costs, commission-free trading apps tend to offer less research and investment information to their customers than established platforms. And their customer support may not be as comprehensive. For example, eToro and Freetrade do not have a customer helpline to phone, but instead communicate with users online or via email. Before trading via commission-free platforms or any other type of broker, make sure you are happy with the level of service they offer. See more on this in ‘The platform functions you need to work’ in the issue of 7 February.

Freetrade customers have complained that they have not received the price they were expecting when dealing in stocks. But the platform reserves the right to aggregate orders if it considers that this is necessary, resulting in a delay to the trades. Freetrade’s terms and conditions state: “You should be aware that aggregating orders in this way may be to your disadvantage. Because your investment may be bought or sold alongside the shares of other customers, the price obtained may not be the same as if it had been an individual order.”

However, this can also work to users’ advantage if the price moves more in their favour between them placing the order and the trade being made. 

When you deal in fractional shares, rather than buying a whole stock, you rely on your broker to buy back the fraction from you when you want to sell. This is because fractions cannot be traded on markets. And if you decide that you want to change broker, you cannot transfer fractional shares to another platform. 

Trading frequently, even if it is free, may not be a good idea if you are investing for the long term because it can result in you losing more money than if you had just held the securities, due to buying and selling at the wrong times. This is a particular risk for novice investors, especially if they trade exotic financial instruments such as CFDs that are more suitable for experienced and professional investors.

Robinhood, meanwhile, benefits from customers making high numbers of trades due to a practice known as payment for order flow, which is common in the US, but illegal in the UK. This is when larger brokers trade on behalf of smaller ones bundling orders together to keep costs lower. As the larger broker benefits from the additional share volume it handles it compensates the smaller brokers, such as Robinhood, for outsourcing those trades to them.

Source: providers, July 2020