what you are not told

It is obvious that, for many investors, the choice of their stock broker will be made mainly on the basis of the transaction fees applied by the latter. Brokers offering a “zero commission” offer have been on the rise for a few years. However, it must be understood that free access can sometimes reveal unpleasant surprises and ultimately an additional cost that investors cannot measure.

We will see in this article that there are many ways for a stockbroker to execute the purchase or sale of a security and that the transactions do not always take place on the stock exchange.

Off-exchange executions

If a few years ago, it was not necessary to ask the question concerning the way in which our orders to buy or sell securities could be executed, times have changed and the arrival of the Internet, although that having enabled many innovations, has greatly changed the landscape of the stock brokerage industry.

If investors who started trading in the 1980s/1990s have kept the habit of calling it the “Paris Stock Exchange”, the main stock exchange where French shares are traded is now called Euronext Paris. However, buying a TotalEnergie or Danone share does not necessarily mean that your transaction will go through Euronext Paris.

In fact, if your stock broker offers you to buy and sell shares without commission, it is even almost certain that your order will not go through the stock exchange but on a “dark pool”. Stock market orders can also be executed over-the-counter (OTC) directly with a liquidity provider (market maker) or on a multilateral trading platform (MTF).

While traditional stock exchanges operate in complete transparency with an auction system allowing investors to be sure of always obtaining the best price at the time T, alternative places, such as dark pools or other similar modern “stock exchanges”, are much more opaque in their mode of operation. Moreover, the name “dark pool” means in French “dark sea”, a term that is very representative of the way in which orders will be executed.

It is therefore essential to check with your stock broker how the orders are executed because the few euros saved in brokerage fees could only be the hidden face of a much more costly mechanism for retail investors.

Read also our article Stock market fees: how not to be fooled

Agreements between brokers and market makers

Like brokers, market makers play an essential role in the proper functioning of financial markets. Their role is to ensure liquidity so that buy and sell orders can be executed quickly and at the right price. Earning money on the spread (the difference between the purchase price and the sale price), their role is not always easy, especially when the markets are volatile.

However, there are very specific cases in which the processes are much simpler and arranged in advance thanks to agreements between stock brokers and market makers.

The agreements in question allow brokers to offer free brokerage fees by bypassing the execution of orders on the stock exchange in favor of direct execution with the market maker. No longer in competition with the prices offered on the stock exchange, the market maker can carry out the purchases and sales of securities at a price with which it is sure to generate a profit… A price which will no longer necessarily be in favor of the investor but in favor of the market maker.

The stockbroker, for his part, will receive a fixed or variable remuneration making it possible to include free transactions in his offer. It should be understood in this case, that free orders will only be an illusion since the investor will sometimes find himself paying even more in terms of executed price or spread.

Also see our article Brokerage fees: how to lower the bill with brokers

The payment of transaction flows (and its regulation)

A new “business model” in the world of stock brokerage, which already exists in the United States, has appeared in Germany for several years, in particular thanks to less stringent regulations than in France. This is the “Payment for order flow” (PFOF) which we can translate into French as “payment for the routing of stock market orders”.

The principle is simple, the stockbroker is paid by private companies (MTF/dark pools/alternative stock exchanges) which seek to compete with traditional stock exchanges to receive purchase/sale transactions from investor clients.

This is how some stock brokers manage to offer brokerage on the stock market without commission, and everyone could find their account there if the orders are executed under the same conditions as on one of the major European stock exchanges. However, this is unfortunately not the case and if these dark pools manage to remunerate brokers to receive orders from their clients, it is because the orders are executed at a disadvantageous price for the investor. Note that the routing and execution of stock market orders normally represents a cost for a stock broker.

The online broker offering free commissions may thus appear more competitive when in reality the absence of fees is compensated by a worse/deteriorated execution price. An additional cost impossible to measure for a particular investor. It is also important to specify that some stock brokers lower prices and/or offer free fees, but still send orders to the stock market to ensure price competitiveness, but it will always be difficult if it is not impossible to distinguish stock brokers who apply this good practice from those who do not.

Being very difficult for an investor to be able to know if his transaction has been executed at the best price and under the best conditions, there is a big problem of ethics and transparency since the investor thinks he has paid less (commission free) when he may have paid more in the end (disadvantageous purchase price).

See also our article Stock market commissions: what impact on performance?

Is all of this legal?

In a European regulation which seeks to impose always more transparency, it is legitimate to wonder if all this is legal.

However, it is not easy to answer the question in the absence of a precise rule applicable throughout Europe on the subject. Indeed, in Germany this practice is authorized and it is also there that we find the most important neo online brokers using this “business model”. In France, the AMF condemns this practice of PFOF but this does not prevent other European brokers operating in this way from offering their services to French investors through the European passport.

Moreover, even if the practice is condemned in France, it exists in a roundabout way. Indeed, online brokers who cannot receive compensation from dark pools will be offered free access to many services that are normally very expensive for them.

It would therefore seem that the practice is even more opaque in France, since Bourse brokers receive benefits instead of a payment, and the retail investor will not benefit from the system since he will pay stock exchange fees for the execution of its transactions, whether it is actually carried out on the stock exchange or on an alternative place at a disadvantageous price.

Good news: European regulations aimed at prohibiting practices that are unfavorable to investors should help investors to see things more clearly in the future.

Read also our article Investors, what does the AMF do for you?

Private investor, what should I do?

Now that you have understood the different tricks that stock brokers can put in place to reduce costs or even obtain additional income, you are able to choose the stock broker that will suit you best with full knowledge of the facts. It will of course always be essential to compare brokerage fees from one broker to another, but by checking in the general conditions how orders are executed and on which stock exchange, you will be able to objectively compare the brokerage fees applied. by the various brokers and their quality of execution.

Also consult our file How to invest in the stock market? Our step-by-step guide

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All of our information is, by nature, generic. They do not take into account your personal situation and do not in any way constitute personalized recommendations with a view to carrying out transactions and cannot be assimilated to a financial investment advice service, nor to any incentive to buy or sell instruments. financial. The reader is solely responsible for the use of the information provided, without any recourse against the publishing company of Cafedelabourse.com being possible. The responsibility of the publisher of Cafedelabourse.com can in no way be held liable in the event of error, omission or inappropriate investment.

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