The market of stockbrokers has been shifting since a couple of years. Several newcomers are offering so-called no-fee trading: free stock trading on designated exchanges or particular stocks. What is driving these new business models?

A brief introduction into exchanges

Stockbrokers are executing orders to buy and sell stock for their clients on an exchange. Traditionally, their business model is based on fees that are paid for every order that is being executed successfully. For example, buying 200 shares of Shell might cost you 6 euros in fees.

However, not all exchanges are created equal. Sending the same order to multiple exchanges might result in different prices. This has to do with the fact that exchanges are matching buyers and sellers on the exchange itself, not on the market as whole.

Market makers

The matching of buyers and sellers isn’t really about matching two individuals. This would make the stock market illiquid, as you need to wait till someone else is willing to do the opposite trade. For example, you would have to wait for some other party who is willing to sell at least 200 shares of Shell.

Instead of trading with another individual, you are mostly trading with a market maker. A market maker is a party that has both a permanent buy and sell order with a large quantity open on an exchange. There is a small difference between the buy and sell prices that are being quoted, which is known as the spread. If an individual trader sends an order to the exchange, there is a big chance that it is being fulfilled by the market maker. The spread enables the market maker to make money, because it is continuously selling the stock at a slightly higher price than it is buying it.

Payment for order flow

As you can imagine, it really matters on which exchange your order is being executed. Different exchanges might have different agreements with market markers or act as a market maker themselves.

For an exchange that also acts as a market maker, the execution of orders are profitable in itself due to the difference in buy and sell prices. This has evolved in such a way that exchanges are compensating stockbrokers that are routing the orders to their exchange. This phenomenon is called payment for order flow, or PFOF for short.

In the Netherlands, a stockbroker is obliged to always act in the favor of the client. This makes it illegal to route orders to other, more expensive exchanges. However, in Germany, brokers are regulated under the Bundesanstalt für Finanzdienstleistungsaufsicht. Which does not have this condition.

Now Flatex has acquired DeGiro, basically all De Giro customers are not protected by Dutch regulation anymore, which also allows them to route orders to less favorable exchanges.

In practice, you are free to choose the exchange that is being used, but you can see that they are pushing towards certain exchanges. Moreover, they are promoting trading outside the regular trading hours, which is only possible at their preferred exchange.

Final thoughts

All in all, I think it is important to know how a stock trade comes into being, as I am not a fan of obscure business models. A retail investor that is buying some shares with a limit price is probably not that much affected by this structure. However, with low volume products, such as options and high quantities, it might cost you serious money.