The Hidden Costs of Zero-Fee Brokers

Hello Stoic Investors,

Today, I want to talk about something that’s becoming increasingly common in the investing world: Zero-Fee Brokers.

At first glance, these platforms seem like a great deal—no commissions, no obvious costs.

But like any business, brokers need to generate revenue, and one of the ways they do this is through a practice called order flow.

What fees do you pay with your Broker?

Let’s first understand what fees you generally need to pay with your Broker.

A Broker is a business and somehow, they need to make money.

And so, every time anything is free you should be very skeptic, because there’s always some trick behind the scenes, and it's important to understand how to recognize them.

First of all, the typical fees of a broker are three:

1. Fixed Fees:

This means you pay a fixed amount per month for the broker that you have.

2. Per-trade Fees:

With these fees you pay a percentage or fixed amount every time you buy or sell an asset.

It may look something like this: Every time you buy, you invest $100 into a stock, you pay maybe 0.5% of the investment value or maybe a fixed $1.

3. Asset Fees:

You pay a percentage of your total investments value every year.

I suggest you to avoid this type of fee because it becomes very big the more money you have, and maybe for even not doing anything.

So generally, I prefer something that is fixed because it's very transparent, or per-trade if I don't plan to invest so often.

But asset fees is something that I want to avoid.

The Hidden Cost of Zero-Fee Brokers

Now, if a broker isn’t charging you directly, they still need to make money somehow.

One common way is through Payment for Order Flow (PFOF).

This means the broker sells your trade orders to large institutions, which then execute the trades on your behalf.

The problem is that these institutions may not always give you the best price.

To understand what order flow is, we need to first understand the concept of bid-ask spread.

Bid-ask spread simply means the difference between the best offer to buy and the best offer to sell.

In the moment in which two people have the same agreement, like the seller wants to sell for €100 and the buyer wants to buy for €100, exchange happens instantaneously.

But as long as there's a difference between the best buying price and the lowest selling price, you will have a spread, that’s a difference.

In a competitive market, this spread is small.

However, when a broker sends your order to a market maker instead of the open market, the price may be slightly adjusted in their favor, meaning you pay a little more or sell for a little less.

Now, let’s go back to the concept of order flow.

Order flow is the process through which brokers send customer trade orders to third parties—usually market makers—rather than directly executing them on a stock exchange.

The reason brokers do this is simple: market makers pay them for it.

These market makers profit by slightly adjusting prices to their advantage, making small gains on every trade they handle.

Instead of executing your trade at the best possible price available on the open market, the market maker might offer you a slightly worse price.

This could mean paying a little more when buying or receiving a little less when selling.

The difference might seem small, but over time, these small costs add up and effectively act as hidden fees.

For example, if you buy a share of Apple through a broker that doesn’t engage in order flow, you might pay €100.

But with a zero-fee broker using order flow, the price could be €100.50, with the extra cost going to the market maker.

You still get the stock, but you’ve unknowingly paid more than necessary.

While this may not seem like much on a single trade, across multiple transactions, these hidden costs can significantly impact your returns.

How to avoid paying for order flow

So how do we avoid this?

First, always ask yourself "If I'm not paying for this service apparently, how can this company make money?".

This is true for brokers that are commission-free, but it's true for many other things.

So every time something is free, ask yourself why.

And second, just search on Google the broker that you have and see if they do payment per order flow because luckily, they need to tell us by law.

So you can understand this just by checking on Google.

Remember, always approach 'free' offerings with skepticism, as there's often a cost hidden beneath the surface.

So, note down these key points and start investing today:

1. The typical fees for a Broker are: Fixed Fees, Per-trade Fees and Asset Fees

2. Commission-free brokers earn through hidden mechanisms like order flow, inflating stock prices.

3. Brokers use the bid-ask spread to add hidden fees to trades.