The internet and smartphones allow a completely different retail trading experience than was possible mere decades ago.

Instant buys and sells with the click of a screen, real-time data, trading fractional shares, and of course, zero-fee trades. Brokers like Robinhood, Trading 212, Freetrade and a plethora of others have now sprung up.

But how do those brokers actually make any money? Are we actually ending up paying more? We investigated and report our findings below.

We share our ultimate view on zero-commission brokers and how they are best used.

What is commission-free trading?

Commission-free trading means that you can buy or sell a share without being charged a fee.

Historically, brokers have attracted customers by undercutting their rivals when it comes to trading fees or offering certain perks. Brokers that charge higher fees, such as Hargreaves Lansdown, justify their fees by claiming to offer a more ‘premium’ experience, from a better customer service to a larger variety of stocks.

In 2014, Robinhood came along and disrupted the US brokerage industry by not charging any fees for trading shares. Sensing the threat, many brokers followed this trend.

A broker is in the business to make money, and there are a few ways zero-fee brokers make money:

• Fees for a premium account (e.g. an ISA or SIPP Account, or an account that allows overseas investing too)
• Withdrawal or deposit fees
• Foreign currency exchange fees
• Interest on cash you hold in your account (this traditionally account for around half of the revenues of larger brokers)
• Margin lending (this is not halal for Muslims to do, so if you are offered the option of opting-in or out, you should opt-out. The reason is short-selling involves buying and selling that which you don’t own, and profiting from that would be impermissible)
• Rehypothecation
• Payment for order flow

Don’t worry – we’ll explain all the complicated terms below.

Understanding rehypothecation and payment for order flow

Rehypothecation and payment for order flow (PFOF) are all the rage in zero-fee broker business models so it’s important you understand them if you choose these brokers.

Rehypothecation sounds complicated, but all it means is when a broker uses the stocks you own as a collateral for their own market activities.

An example of rehypothecation is when a broker participates in share lending by allowing short sellers to borrow your stock. It’s your stock that is being used, but the broker gets the “rent” for it.

Then we have PFOF, which has become the de facto stable revenue stream for a lot of brokers.

The Securities and Exchange Commission (SEC) in the USA defines it as: ‘Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.’

What this means is that brokers will make deals with specific market makers and agree to route your buy and sell orders to them, in exchange for this special deal, your broker receives a small compensation.

Why does the market maker pay for your order? Because they make money on the spread between the bid and ask price, so the more orders they receive, the more money they make. It’s also interesting to note that in this age of quants and algorithms, order data is very valuable for computers to keep track of the market. And with free trade apps now making significant volume in the market, having that order data ahead of everyone else is really worth paying for.

Popular commission-free brokers and how they make money

There are a range of brokers offering zero-fee trades that are easy to sign up to.

But it’s important to understand that nothing is truly free, and while a commission-free broker does not charge you for trading upfront, they make money in other, more indirect, ways. You should understand these costs before you sign up.

1.      Trading212

Probably the most famous name in commission-free trades in the UK, Trading212 was founded in Bulgaria in the mid-2000s.

After entering the UK market in 2016, Trading212 began offering zero-fee trades in the footsteps of Robinhood across the pond. This has led Trading212 to become the most popular broker of this category.

How does it make money?

• CFD costs: Trading212 has a CFD account which functions differently to the usual stock trading in their ISA and ‘Invest’ accounts. CFDs are derivative instruments which are not Islamically permissible. The CFD account has costs associated with CFD losses and holding positions overnight and over the weekends. Also the counterparty to your CFD trade is often T212 itself, and as most retail investors lose money when investing in CFD, T212 make a nice profit here too.
• Spreads: In addition to the above, most brokers in this category will make money through the spread between the bid and ask price. Trading212 is no different in this regard.
• Currency conversion fee: Trading212 charges a flat 0.15% fee to convert your currency into the home currency of the asset you are investing in. So as a UK resident investing in American companies, every trade will cost you a 0.15% conversion fee. Sure, they’ll have to pay a little bit of that to the underlying payment company that handles the payment flow, but they’ll definitely be keeping a cut.
• Deposit fee: If you use certain payment methods, such as a credit/debit card or Google Pay, for example, there is a 0.7% fee once you have deposited £2,000 in total using these methods. Linking your bank account will give you unlimited free deposits. T212 are probably not making very much here though – they’re likely just passing on the card providers’ cost to you.

2.      Freetrade

Founded in 2016, Freetrade is a British startup that aims to be the Robinhood for the European market.

Freetrade’s whole premise is zero-fee trading and ease of use for the retail investor.

How does it make money?

• ISA account: Unlike Trading212, Freetrade charges a monthly fee of £3 for maintaining an ISA account. Their general taxable investing account is free, however.
• SIPP account: Freetrade offers a Self-Invested Personal Pension (SIPP) account for £9.99/month, creating another stream of stable revenue.
• Freetrade Plus: A premium service upgrade where you pay £9.99 a month for benefits such as a wider variety of stocks, priority customer service, a 3% interest rate (which would render this option impermissible unless you donated that interest), and curated stock collections.
• Currency conversion fee: Like Trading212, Freetrade charges a fee for purchasing shares in another currency. In this case, the fee is 0.45%, slightly higher than Trading212.
• Interest: Like many other brokers, Freetrade earns interest on cash held in customers’ accounts.

3.      Etoro

Etoro is an Israeli company founded in 2007. They began offering services to the UK market in 2013.

They offer a wide range of stocks and notably also offer cryptocurrencies.

How does it make money?

• Withdrawal fee: Etoro charges a hefty $5 fee for withdrawals of funds.
• Spreads: Etoro makes money through spreads on many of its offerings, from stocks and CFDs to cryptocurrencies. They outline different spreads for different instruments.
• Currency conversion: Etoro natively supports USD. Any deposits or withdrawals in any other currency will incur a fee of at least 0.5%.
• Inactivity fee: If you don’t log in for 12 months, a $10 monthly inactivity fee will be taken from any remaining balance you hold with Etoro.
• CFD costs: Just like Trading212, Etoro also makes money from CFD traders, such as through overnight fees.

4.      IG

IG is a British trading platform and a constituent of the FTSE 250 index.

It was founded in 1974 and is considered one of the veterans of the British brokerage industry. Technically, IG is not a completely zero-fee broker since it is only zero-fee for US shares.

How does it make money?

• Non-US share dealing: IG charges a £3 fee for dealing in shares when you trade three or more a month. But it’s zero-fee for trading US stocks.
• Currency conversion: A 0.5% foreign exchange fee is charged when dealing with shares in an international market.
• Phone dealing: Being a veteran of the industry, IG continues to offer phone dealing services, a relic of a bygone age. But this service comes at a premium of £40 for UK shares and £50 for US and European shares.
• Custody fee: If you don’t make at least three trades in a quarter, a flat custody fee of £24 is charged and automatically taken from your balance, or your account is overdrawn if there is no balance.
• Same day bank transfer: If you deposit less than £100 by same day bank transfer, a fee of £15 is taken.
• Various CFD and spread betting fees: For customers of the CFD and spread betting services, IG has a range of fees such as overnight and spreads.

The pros and cons of using a commission-free broker

The pros

1.      Frictionless

Commission-free brokers were born in the age of the smartphone. They’re tailored towards younger millennials and Gen Z whose primary mode of access is through apps.

These brokers offer a seamless app experience with a navigable UI whose whole purpose is ease of use and zero friction.

From opening accounts online with ease and sending orders with a minimal amount of clicks, this category of brokers is known for a hassle-free experience.

2.      Democratised trading

With the advent of commission-free trading, the average person can invest in a wide variety of stocks with as little as £1.

Gone are the days of high minimum balances and extortionate fees. Fractional shares allow the retail investor to purchase parts of shares, so you don’t actually have to spend thousands on a single share of AMZN.

Zero-fee brokers caused a ripple effect in the industry and have caused other brokers to realise that unnecessarily high fees cannot be justified in this market. Competition is a good thing for the average investor!

3.      A healthy portfolio

In the era of high fees, a massive consideration when choosing a broker was how the fees would detract from your overall portfolio in 10 years’ time.

You would have to calculate your projected return and subtract the massive cut that would be given to the broker from your investments.

This worry does not exist anymore, at least not at the level it did.

The cons

1.      ‘Hidden’ fees

We’ve explored the amount of indirect fees charged by these brokers, however small they may be. And while these fees are not necessarily ‘hidden’, the commission-free moniker can make it seem like the fees are negligible.

You would be wrong to think that of course. Once you’ve been investing for a few years and your portfolio grows an order of magnitude even these small indirect fees will hit your portfolio.

2.      Rise of meme culture and herd mentality

Now that it is so easy for everyone to just invest any amount of money they want with zero barriers, it is easier to get sucked into meme-culture and follow the herd.

High fees of the past would make you think twice about trading a stock because your wallet would take an immediate hit. This barrier is no more, so meme stocks This barrier is no more, so meme stocks abound.

This is bad for the average investor if it causes you to partake in an unnecessary speculation with your money.

It’s also extremely telling that most of these apps do not have advanced stock research, data, or screening functionality. If you’re not even providing that, how is your customer set up to actually invest in something that is properly researched, understood and worthwhile?

3.      Payment for Order Flow and rehypothecation

There is a famous saying on the internet, if the product is free, you are the product.

This rings true when it comes to commission-free brokers. While these brokers have genuinely helped the average retail investor get started in the market, there is a cost.

You have become the product.

Whether it’s your shares being lent to others or your order flow being sold to make money or your data, it’s important to understand how and why brokers can offer such an enticing package.

That doesn’t necessarily mean, by the way, that you are getting a costlier or worse service (the FT did a great article on this), but it is important to fully understand the bargain you are making.

4. Stock coverage is less

zero-commission brokers often do not cover smaller stocks – or if they do – they charge for that. They also usually don’t have anywhere near as extensive a coverage of funds, ETFs and other instruments. This is particularly relevant for sharia-compliant investors as they are often looking for more niche products.

Conclusions

Our view is that overall zero-commission brokers are definitely a viable and usually cheaper way to invest. Their coverage is less for certain sharia-compliant funds so that’s one thing to watch out for.

Overall, a clever way of using zero-commission brokers is to get ideas off places like the IFG Fund Replicator and then invest in them via the zero-commission brokers. Because the thing that these zero-commission brokers lack are tools to help you generate good investment ideas.

For more reading you should definitely check out our head-to-head comparison between mainstream brokers and low-cost brokers.

For a guide on halal investments, visit our curated list reputable Sharia-compliant providers.