Economics behind commission-free trading

To illustrate how this works, let’s suppose the bid of Company XYZ stands at $99.00 and the ask sits at $100.00, creating a spread of $1. An investor wants to purchase shares of XYZ at the mid-point of $99.50. That order goes from investor to brokerage and then reroutes to a market maker. The market maker may offer to sell at $99.50, but not before purchasing those shares at $99.40, pocketing the difference of .10 cents in the process. So while the investor recognizes some price improvement, they’re not receiving the best execution, losing value overall.

Brokerages have a fiduciary duty to offer investors the best possible price. So how do brokerages make money on these transactions? Brokerages and market makers have pre-existing contracts in place, whereby market makers pay brokerages a commission for sending their trade orders to them, instead of the exchanges. Taken all together, brokerages make money from these contracts, market makers produce profit inside the bid-ask spread and the investor… loses value in their portfolio.

Investors use brokerage services to buy or sell stocks, options, and other securities, generally expecting good execution quality and low or no commission fees. But they might not know the broker's PFOF arrangements. While investors don't directly participate in the arrangement, how well their trade is executed can be affected by it.