How a free trade is paid for

A commission of zero is a price, not an absence of revenue. A broker that charges nothing to trade is being paid in other ways, and all of them are disclosed somewhere.

Knowing where the money comes from is not an accusation. It is the only way to read the incentive correctly, and the incentive is not always against you.

The proportions above are illustrative and vary enormously by firm and by the level of interest rates. The ordering is the part worth carrying: for most commission-free brokers, what happens to your idle cash matters more to their income statement than what happens to your orders.

What payment for order flow is

A wholesaler pays a broker a small amount per share for the right to execute its customers' orders. The wholesaler then fills those orders and keeps the difference between what it pays and what it receives, which is the spread.

Retail orders are attractive to a wholesaler for a specific reason: they are small and, in aggregate, uninformed about very short-term price direction. That makes them cheaper to trade against than orders from a firm that may know something, and the wholesaler will pay for access to them.

The obligation that constrains it

A broker owes its customers a duty of best execution. That duty is about the whole outcome, which includes price, speed, likelihood of execution and likelihood of settlement, and it is not satisfied by pointing at a payment received.

In practice a wholesaler usually fills a small retail order at or inside the published best bid and offer, which is called price improvement. The honest statement is that the arrangement can leave a retail investor better off on price than an exchange fill and simultaneously profitable for everyone in the chain, because the spread is wide enough to share.

The concern that survives all of that is a routing decision made on the basis of the payment rather than the fill. That is exactly what the disclosures exist to expose.

What it means for someone who trades twice a year

Very little, and that is the honest conclusion. The amounts per share are fractions of a cent, and a buy-and-hold investor crosses the spread twice a decade rather than twice a day.

Two things matter more and are in the same disclosures. The interest rate paid on uninvested cash, which is a real number that differs by several percentage points between brokers. And whether your shares are lent out, by whom, and who keeps the fee.

The generalisable point is the one this whole course keeps making. When a service is free, the revenue has moved rather than disappeared, and in regulated markets it has usually moved somewhere that must be published.

Check yourself