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Trade stocks for free

A handful of stockbrokers are ditching trading fees. Cris Sholto Heaton looks at what that means for investors, and why you should be careful.

Giving away your core service for free may not sound a sensible business model. But that's what a handful of stockbrokers are now doing, by ditching trading fees. In December, UK-based iDealing introduced commission-free trading for shares listed in Belgium, France and the Netherlands and hopes to do the same in the UK at some point in the next few years.

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In America, a start-up called Robinhood has won millions in investment from venture-capital firms for a smartphone app that allows no-fee trading in US stocks. And DeGiro, a Dutch broker that has got plenty of media attention for offering very low-cost trading in many European markets (£1.75/share for UK trades) has said it aims to introduce a commission-free service this year.

It should be pointed out here that these are all relatively small firms (although iDealing has been in business since 2000 and was one of the UK's first online brokers) and the zero-commission business model remains unproved: at least one US brokerage (Zecco) tried this from 2006-2011 and was unable to make it work. But the idea is intriguing.

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So how can a stockbroker consider giving up what has historically been their main revenue?Part of the answer lies in minimising those costs that are closely linked to howactive clients are (otherwise, the morethey trade, the more it costs the broker).

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This means bringing in-house services such as clearing (ensuring that a trade is completed), settlement (the final exchange of securities and cash) and custody (holding assets for clients), as well as developing the software systems for trade execution (which most brokers license from third-party developers).

The extent to which the handful of firms now trialling zero-cost trading do this varies. For example, iDealing now handle all these functions in-house, while Robinhood is essentially a software developer that relies on a third-party firm for clearing, settlement and custody. But even if a broker is able to eliminate variable costs entirely, they need to find other revenues to replace trading fees.

This could be explicit fees for account administration and custody, or charging for processing dividends and corporate actions (as iDealing does for European clients). It could also include revenue from lending out clients' securities, as DeGiro does (see below).

In America, brokers can get paid for sending client orders to specific exchanges, but the Financial Conduct Authority (FCA) does not allow this in the UK. But the most important is earning interest on client cash deposits and charging interest on margin loans. This has traditionally been a key source of income for brokers, but has become less profitable in the current low-rate environment. So whether zero-commission trading really takes off is likely to depend on a return to more normal interest rates.

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However, if the economics stack up, eliminating or drastically reducing dealing costs could have some interesting results. While some critics think it could encourage investors to trade too much, it would also let small investors build better-diversified portfolios. And it might encourage brokers to shift away from a focus on transactions towards administering client assets efficiently. Given that UK investors seem to complain more about administrative errors and shakey customer service than about trade execution, this could ultimately be a very positive development.

How safe is DeGiro?

First, some background on how DeGiro works. The firm is part of a group called LPE Capital, which also includes a small hedge-fund manger called HiQ Invest. Orders placed by DeGiro's retail clients go through the same trading arrangements as HiQ Invest (and some trades may be matched directly with HiQ Invest).

DeGiro says that these arrangements are a key reason why the firm is able to offer low rates. Another reason is that DeGiro's standard account allows your securities to be lent out so the firm can earn additional income from this. (It is possible to opt for a custody account, which does not allow your securities to be lent, but this carries extra fees.)

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Major UK stockbrokers do not generally lend retail client assets, so UK clients may not be familiar with the added risks of this. Briefly, when securities are lent, there is the possibility that the borrower does not return them. DeGiro is responsible for the lending process and for ensuring that borrowers provide collateral. This means that clients rely on DeGiro to manage lending risks and ultimately on its pledge to make good any shortfall if there is a default and the collateral is not sufficient.

It's very difficult for an individual investor to assess how robust DeGiro's risk management and guarantee are, so a state-backed investor-protection scheme is a crucial last line of defence against a worst-case scenario. Here it's important to note that DeGiro is not covered by the UK Financial Services Compensation Scheme (FSCS), which pays up to £50,000 if a broker fails and your assets are missing. Instead, it falls under the Dutch scheme, which only covers up to €20,000 (£15,500).

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