How And Why Are Online Brokers Offering Commission-Free Trades?

One of the biggest stories on Wall Street recently was the wave of online brokers that eliminated commissions on all stock and ETF trades.

Interactive Brokers Group, Inc. IBKR, Charles Schwab Corporation SCHW, TD Ameritrade Holding Corp. AMTD and E*TRADE Financial Corp ETFC were among the group that cut trading fees to zero, and their stocks all took huge hits as a result.

Just because traders are no longer paying per-trade fees doesn’t mean brokers aren’t getting paid.

No Free Lunch

Benzinga PreMarket Prep co-host Dennis Dick said online brokers will now be relying more than ever on payment for order flow, or PFOF.

“Off-exchange market makers make payments to retail brokers for the privilege of having their customer's orders routed to them first. The market maker will execute directly against the retail order (if they think they can make money from it). They are basically paying for the privilege of having ‘first dibs’ to trade against the ‘dumb money,” Dick said.

Retail brokers can also collect liquidity rebates that are paid out by the public exchanges. 

“In some cases, these rebates are as high as .003/share, meaning a 1,000-share order providing liquidity would be worth $3 to the retail broker,” Dick said.

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Themis Trading's Joe Saluzzi told Benzinga that order flow is now the name of the game for online brokers.

“These orders will never make it to the public market because they are intercepted by the market makers. This concerns me since its limits the diversity of the order flow in the market and could damage the price discovery process,” Saluzzi said.

How To Play It

While online broker stocks took a beating last week, Morgan Stanley analyst Michael Cyprys said that Virtu Financial Inc VIRT could be an under-the-radar winner from the new zero-commission landscape.

“We could very likely see increased trading activity with zero commission pricing that will result in more order flow going to market makers such as VIRT; they make markets and profit from larger volume of activity,” Cyprys said.

Morgan Stanley has an Overweight rating on Virtu with a $20 price target. 

Wells Fargo issued downgrades among the group and said the combination of slowing organic revenue growth, falling interest rates and disappearing commission revenues will continue to weigh on the stocks.

Wells Fargo said eliminating commission fees has made it difficult to make a bull case for the space at the moment.

Benzinga’s Take

While Virtu could be the near-term winner from the end of trading commissions, the sell-off in broker stocks could ultimately create a long-term buying opportunity for investors. But until the companies prove they can replace lost trading fee revenue via PFOF and other means, attempting to buy the dip is a high-risk play.

Do you agree with this take? Email feedback@benzinga.com with your thoughts.

Photo by Thomas Hundt via Wikimedia.