Zero-commission execution, too good to be true?

March 11, 2020

Broker fees over the last decade have been coming down. There is now even zero-commission execution. We do not believe that high fees are good but is zero-commission execution “too good to be true”? 

This article aims to demystify the zero-commission execution concept so that our clients can understand the amount and likelihood of price improvement they receive on trades where they pay commission versus zero-commission trades.

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There is no free lunch – costs are hidden in the execution price

Brokers are smart and they are not charities. Zero commission brokers sustain themselves by not giving you the best execution price. Such costs are hidden from the investors and can be earned in a few ways: 

Receiving payment for your order

Brokers essentially “sell” your orders. Your orders are generally routed to select over-the-counter market-makers for handling.  Alternatively, the broker may also route your orders to another broker or exchange (each an “Away Route”). In both cases, the broker will collect payment for order flow for trades executed.

No incentive to search the best execution price for you

Because your order is “sold” to the highest bidder, the broker has no incentive to search and send your order for the best execution price. The broker’s interests are not aligned with yours.

Receiving rebate for providing liquidity

Some exchanges, particularly those trading options, impose “maker-taker” fees and rebates, in which exchange members are charged for orders that take liquidity (i.e., marketable orders that trade against a posted quote or limit order) and receive a rebate for orders that add liquidity to the exchange (i.e., non- marketable limit orders that are posted and then trade against incoming marketable orders), or vice versa. 

Brokers would generally route the option orders to an exchange where they will receive the most payment for the order. 

If it is a zero-commission trade order, the broker is likely to retain the rebate but pass you the charge. Thus, affecting your total cost of execution.

A smart system improves execution price

With paid commission, brokers are paid to find the best price rather than the highest kickback fee. Our partner broker would route the orders to their smart execution system whereby it is designed to optimise execution price, speed and total cost of execution for stocks and options.

Saving you USD 4.42 net per trade on average

Based on independent measurements, IHS Markit, a third-party provider of transaction analysis, has determined that our partner broker’s US stock price executions were significantly better than the industry. The estimated net benefit per trade after commission is USD 4.42

How can you get a better execution price?

Our partner broker achieves better execution price by constantly changing and enhancing their system to continually scans competing market centres and automatically seeks to route orders to the best market, taking into account factors such as quote size, quote price, exchange or transaction fees or rebates and the potential availability of price improvement (execution at a better price than the National Best Bid or Offer (“NBBO”), “Price Improvement”).

Your orders are not sold

With our partner broker’s smart system, unless you direct the order to a specific market centre or “algo” provider, the system retains control over the routing of the order for execution, and does not deliver the order for another broker to route. Hence, you get the best price.

How about alternative trading venues?

Alternative trading venues are usually associated with dark pools where blocks of shares can be executed without exposure while finding buyers and sellers. This prevents heavy price devaluation, which would otherwise occur. 

IB’s alternative trading system improves the best quoted price

Our partner broker also operates an Alternative Trading System (the ATS) on which it executes client orders against each other or against one or more professional liquidity providers who send orders into the ATS. Order executions on the ATS are faster, eliminate exchange fees, and may offer Price Improvement. Statistical information regarding the quality of executions for orders effected through the ATS (e.g., average execution speed, percentage of orders receiving Price Improvement, etc.) is available on the IBKR website at https://ibkr.com/regulatoryreports.

Orders execution is as important as stock selection

How your trade orders have been executed influences your entry prices and your investment return. Crea8 believes in a low-cost proposition throughout the investment value chain. However, zero-commission execution is “too good to be true” as it comes at the expense of poorer execution price. 

Crea8’s Advice

Although zero commission broker execution has been becoming more popular, it is important to keep track of the hidden costs associated with this.

We know that hedge funds and institutional investors do not use zero-commission trade execution. As such, we would rather follow the smart money, be transparent, pay for our execution and get better prices.

If you want to learn more

For further insight into our investment methodology including how we strategically manage transaction costs from the design of strategy, cost estimation, portfolio construction and execution of orders, check out our white papers.

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