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With Free Trading...You Get What You Pay For Thumbnail

With Free Trading...You Get What You Pay For

As competition for wallet share has stiffened in the discount brokerage world, the industry has found itself in a 'race-to-the-bottom' on trading fees, leading many firms to offer free, no-commission trades. Spurred by the meteoric rise of the no-commission brokerage app Robinhood, competitors have slashed their trading fees to $0, a move that should have severely hurt them financially. Yet, reported financial results show us something different. 

Surprisingly, the discount brokerage quartet of Charles Schwab, E-Trade, Interactive Brokers, and TD Ameritrade increased their trading revenues by nearly 30% from 2Q2019 to 2Q2020 after offering free trades. How? From the hidden costs of free trading.

Although not directly charging clients anymore, discount brokerages can still monetize trading at their clients' expense. 2018 saw the beginning of a massive increase in Order Routing Revenue at those discount brokerages. Payment for Order Flow/Routing occurs when brokerages sell client trade orders to 3rd party firms to process. These 3rd party firms act as market makers, making money off pairing buyers and sellers and pocketing the spread, or the difference between what the buyer was willing to pay and the seller was willing to accept.

As a result, retail investors might not always have their trades executed at the "National Best Bid or Offer" (NBBO). Order Flow/Routing means that client orders are sent to anyone willing to pay for them. Often algorithmic trading hedge funds and high-frequency trading firms are happy to pay for the order flow to see the orders and act on them before they are executed for the client. While certainly not ideal for the client, at least there's a guarantee somebody will fill these orders.

As discount firms grow in popularity, there has been a rise in the number of times their platforms go down, making it temporarily impossible for a client to access their money or place trades. And more frequently, these outages come at the absolute worst moments, when unusual market activity increases their websites' strain as concerned clients attempt to check their account and place trades. Most notably, in the last week of February and the first week of March, a two week period where markets fell over 10% with massive daily moves over 5% up and down, the discount brokerages each experienced their extended periods of downtime and inaccessibility. At one point, Robinhood's app was down for the entire day, locking out investors on March 2nd while markets moved 4.5%. Although the outages at discount brokerages were frustrating for many investors, these events might have been beneficial in preventing bad decisions.

Successful investing requires objective and disciplined decision-making. It's essential to view investment decisions in terms of your long-term goals. Ongoing trade wars, a contentious election, civil unrest, a global pandemic, and an uncertain economic outlook has prompted many to second-guess their investment strategy. Making impromptu changes based on the daily news cycle can be disastrous for your portfolio.

The discount brokerages offer a valuable service by providing greater market access to those who might not have previously invested. However, unstable times call for a higher quality investment experience. A dedicated financial advisor can help you remain objective and disciplined through the cycle of market emotions. With some of the nation's top advisors and a dedicated network of experts at Baird, we continuously work to ensure your unique needs and goals come first.

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All investments carry some level of risk, including loss of principal. This report does not provide recipients with information or advice that is sufficient on which to base an investment decision. This report does not take into account the specific investment objectives, financial situation or need of any particular client and may not be suitable for all types of investors. Robert W. Baird & Co Incorporated