ECU College of Business research: How free is free? Retail trading costs with zero commissions

Article

How free is free? Retail trading costs with zero commissions

Publication

Journal of Banking and Finance

Authors

Samuel Adams, Connor Kasten (COB) and Eric Kelley

What does the research explore

This research examines the economics of retail trading costs, specifically in the context of the widespread adoption of zero-commission trading by discount brokers in October 2019. The study analyzes how these changes affected retail investors’ execution costs by looking at payment for order flow, effective spreads, and total trading costs. The goal is to determine whether zero-commission trading actually benefited retail investors or if there were hidden costs associated with the change.

What are the practical implications of this research?

The findings suggest that eliminating commissions has led to a significant reduction in retail trading costs, even when considering potential increases in execution costs. This implies that zero-commission trading benefits retail investors as their overall transaction costs have decreased.

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What types of practitioners can take action based on your research?

Financial Advisors and Brokers – With commissions of many discount brokerages being cut to zero, many financial advisors and brokers need to reevaluate their value proposition to clients. In addition, some clients may be curious about their execution quality, so financial professionals should be able to answer a client’s questions regarding transaction costs.

Politicians and Regulators – Our paper helps inform policy debate around PFOF and suggests that claims to ban the practice due to investor harm may not be appropriate. Our paper additionally suggests changes to reporting standards for execution quality. Specifically, our paper exposes shortcomings in how market makers and brokers disclose execution quality. We find that NBBO-based measures overestimate economic benefits. Policy makers could easily alter disclosure to better capture the underlying economics. One improvement would be to require execution-based benchmarks rather than using the NBBO as the basis for computing price improvement. Another improvement could change the NBBO definition to include odd-lot quotes that often lie between the best bid and offer. The Securities and Exchange Commission’s adoption of the Market Data Infrastructure Rule in 2020 makes progress as it contains elements along both dimensions. More recently, the Commission amended Rule 605 in 2024 to modernize the included metrics and require that large broker-dealers report execution quality statistics just as market centers currently do. (It must be noted that a prior version of our paper was also cited in the SEC’s Final Rule in 2024.)[1]

What are the top three takeaways from your findings?

The adoption of zero-commission trading has led to a substantial reduction in total trading costs for retail investors, primarily due to the elimination of commissions outweighing any minor increases in execution costs.
The study finds little evidence to support the idea that brokers are recouping lost commission revenue through increased payment for order flow or significantly higher execution costs. Despite regulatory concerns, the findings indicate that the competitive environment among brokers has effectively passed on the benefits of zero commissions to retail investors, challenging the notion that such trading practices harm investors.
The execution quality reporting requirements required by the SEC had some shortcomings. It often overstated the economic benefits of price improvement and left out execution statistics for trades under 100 shares. Recent changes in SEC reporting requirements have been made to address some of these shortcomings. ***Note: we most likely did not directly cause the SEC to make these changes, but believe that we further rose awareness to issues that were already areas of concern and investigation.

[1] https://www.sec.gov/files/rules/final/2024/34-99679.pdf