This article breaks away from my current “Wish I Had Known” series, but is VERY interesting, especially to anyone who trades their own account through a discount online brokerage… it will blow you away – and yes, I wrote it (it’s not copy and pasted from somewhere else)
Are You Part of the Product Being Sold?
We live in an age of information and innovation. New tactics, business models, and companies have changed the way we operate fundamentally. Many of these new services have millions of users – with Facebook passing 900 million users worldwide. But, have you ever wondered, why Facebook, LinkedIn, Twitter and other online services are free? Surely if Facebook could charge just $1 per user, they could instantly add a huge revenue line to their income statement. However, there are several reasons why they don’t do this, here are two:
- They have developed indirect revenue streams – instead of confronting the user with an upfront cost, they have developed ways to ‘monetize through the side door’. For Facebook, this means free membership and usage, but selling that usage information and demographic data to marketers and ad agencies. For Twitter, that means getting information in front of you that you would not normally see (through promoted tweets). For LinkedIn, that means charging for special privileges. For Google, it just means making sure that you see paid ad’s when you are searching for your content.
- Decreased technology costs combined with increased technology adoption – the customer base simply has access to more powerful technology then they ever have in history. Most families have at least one computer in their home, and many people are always with their Smartphone. Combine that with the fact that price of these products has rapidly dropped, and the ecosystem is fertile for new technology based products – machines literally intertwine with everything we do.
Lessons Learned from Wall Street, or by Wall Street?
These free services have brought on a very fundamental paradigm shift in consumers of all products – we prefer not to pay upfront fees. The question that arises is: if a company doesn’t charge you upfront, how do they cover their costs, or even generate revenues? The famous adage applied to the technology community is ‘that if you aren’t paying for the product, you are part of the product being sold’ – the question is, did Wall Street finally figure out how to do it too?
Firstly, let’s look at the traditional structure for buying or selling a share of any company: you choose the company, call a brokerage, tell them how many, then pay a commission – as they execute the order. That commission (traditionally on a per share basis) represents revenues given to the broker to cover costs such as execution, technology, payroll and overhead. Over time though, those costs have come down as technology has made electronic access cheaper and cheaper (see above).
SURETRADE, created in 1997, was one of the first online brokers of the dotcom era – it was also the first to take on a radically new business model: no retail branches and a flat $7.95 fee per trade for trades executed through their internet platform. By 1999, discount stock brokerage behemoths like Charles Schwab and Fidelity took notice of the online brokerages success and soon changed their commission to a flat fee structure. Through several different steps SURETRADE ending up being acquired by Bank of America Securities in 2004 with the acquisition of FleetBoston. The man who founded SURETRADE – Donato A. Montanaro – ended up going on to launch another independent online brokerage called TradeKing – and although we can’t dive any deeper into SURETRADE (which is now defunct), TradeKing is alive and well, so let’s continue our story there.
As retail broker began establishing the idea of a fixed fee (independent of order size) price competition began, and as they say, gravity took care of the rest. Slowly the race to $0.00 began, as brokerages undercut each other one at a time. They needed to look for new revenue sources – much like the current technology behemoths; they needed to look for indirect revenues or ‘side door monetization’.
This is where the story get’s interesting. As upfront revenues feel, these brokerages had to start to get creative with how they generated revenue – and they turned to the one thing they had – clients. If they couldn’t charge the client any more upfront, they had to figure out how to make more money with the same process – this is when the practice of selling order flow, know formerly as “payment for order flow”, became a common practice. If that didn’t already sound shady enough, the practice was first prominently used by none other than Bernie Madoff.
For an example: let’s say you as the retail investor want to buy 1000 shares of Microsoft. You go online, enter the order, and pay $4.95 – you now own 1000 shares. However, instead of immediately executing that order, the brokerage turns around and sells your order to someone who might be willing to pay for that kind of information – say an HFT firm – at $0.01 per share. In the end, the brokerage finishes with $4.95 from you, and $10.00 for selling your order – a combined total of $14.95.
If My Cost is Lower, Isn’t That a Good Thing?
The argument arises, “who cares if the brokerage is making $10 off selling my order? It means I pay less!” Yes, you pay less upfront, but the problem is not that they are selling your order, its why would someone be willing to pay for your order; unless they could make more off it then they were paying for it? If you wanted to buy 1000 shares of Microsoft at $20.00, but end up buying it at $20.02, does that represent a cost? The answer is yes: you essentially cost yourself $0.02 in upside because the price moved from where you executed the trade. So all in (with commission) your trade actually cost you $24.95 – with $14.95 going to the brokerage, and $10.00 going to an unknown party who bought the shares off the market at $20.00 before you could, then sold them back to you at $20.02 – maybe it has something to do with the HFT firm buying your order?
It Gets Better
Facebook might not charge you to use its service, but imagine if it charged you if you didn’t upload new information and add new friends every month? Facebook lives off selling the information you upload to ad agencies and curious marketers – but it doesn’t monetarily force you to upload information – and you have to at least give them that.
It’s different on Wall Street. Brokerages will charge you inactivity fee’s – which is essentially saying: if you aren’t generating any orders that they can then turn around and sell, you aren’t making us money – and you as the client need to cover that loss. Sometimes these activity fee’s are based off a year, but sometimes it is only a month – you, as the client in the relationship, need to be generating them business – and if you aren’t, you have to pay for it.
There’s no Such Thing as a Free Lunch
Online gambling sites have a known sales tactic – they offer you a ‘cash bonus’ for buying in: if you put $1,000 on your account, they will give you another $100 to play with, on them. That same tactic has even started to pervade the discount retail brokerage market – time it right, and next time you open an account on TradeKing, you could have an extra hundred dollars waiting for you – but don’t get too excited, just like the online casino’s, they make it all back in the end.
Next time you go to an online discount brokerage that is willing to offer you free trades, a cash incentive, or any other perks, stop and think for a moment – there is no such thing as a free lunch. How are they making up for that outlay; where are they earning back that money? Also, take a moment and look check if your broker sells their order flow – for brokerages that trade in the US, this can be found in a SEC 605 or 606 filing which outlines where they route order flow. Remember, if you aren’t paying for the product, you are part of the product being sold.