Is There a Catch With Free Web Trades?

Free stock trading is the newest twist on the Web, but some say it may be too much of a good thing.

In recent months two start-up brokerages have begun offering commission-free trading to average investors.

They’re following a free trading service launched late last year by American Express Co.

But some analysts and regulators are skeptical. “I don’t like it,” said Laura Unger, a commissioner at the Securities and Exchange Commission. “I think at this point, we want to make the costs of trading more transparent to investors. Free commissions would be a move in the wrong direction.”

The firms pioneering the concept of free trading must generate revenue from Web site advertising, money lending and, often, by reselling investors’ stock orders to other market-making firms to execute.

Analysts warn that the savings realized by avoiding commissions could be more than wiped out if investors get inferior stock prices when they buy or sell--the “quality of execution” issue, which the SEC has been urging investors to focus on over the last year.

The new players in the free-trading business are San Francisco-based start-up FinancialCafe.com and Freetrade.com, a unit of No. 5 Internet brokerage Ameritrade Holding Corp.

A firm attempting to get up and running is Freetradez.com.

Although American Express requires a minimum account balance of $100,000 for its free trading service, there is no minimum balance at FinancialCafe.com. Freetrade.com requires a $5,000 starting balance.

The commission-free feature typically applies to market orders--that is, orders to buy or sell a stock at the prevailing market price. Limit orders--those to buy or sell at a specific price or better--cost $5 at Freetrade.com, for example. But that’s still cheaper than what many discount brokerages charge.

Skeptics say the economics of the business are stacked against the success of the free-trading firms.

“I absolutely fail to see how they can make it,” said Octavio Marenzi, an analyst with Celent Communications, a Cambridge, Mass.-based research firm. “In my mind, the numbers do not add up.”

Frank Mansour, president of FinancialCafe.com, disagrees. He said his company will perform well against such giants as E-Trade Group Inc., which booked $621 million in revenue in fiscal 1999 and has more than 2.6 million customer accounts.

Mansour declined to quantify FinancialCafe.com’s operations since its May 3 launch but said: “We are extremely pleased with the account growth and trade volume.”

Jason Lind, an analyst with US Bancorp Piper Jaffray in San Francisco, said he thinks Freetrade.com might be able to make a success of the no-commission business “because they’re piggy-backing it on to Ameritrade’s existing infrastructure. But some of these other guys, I don’t know how they could possibly do it. You’re not going to do it with advertising.”

Lind noted that the upstarts in the business are going up against established giants with huge marketing budgets.

“E-Trade spent more than $150 million on advertising in the first quarter,” he said. “You’re some start-up and you want to go up against that?”

But the more pressing issue, especially to regulators, is the quality of trade execution.

Commission-free trading will attract some customers to the new Web sites, Marenzi said. But the sites must provide customers with the best possible price for their trades to keep them coming back, he said.

“There’s a higher risk with [the zero-commission start-ups] than with most other players that they will have worse [execution] prices,” Marenzi said.

For example, an investor who wants to buy 100 shares of Ford Motor Co. when the stock’s current market “bid” price is $43.50 and the “offered” price is $43.63 could easily end up paying that offered price if a brokerage simply fills the order at the market.

On the other hand, a firm making an effort to get the best price for its customer could conceivably get a price between $43.50 and $43.63. An improvement of 6.25 cents a share in a customer’s price adds up to $6.25 on a 100-share trade. On more thinly traded stocks, the difference could be much more significant.

“If there’s commission-free trading, customers are going to be paying for the costs in some other way,” Unger said.

Critics say commission-free brokerages have more incentive to direct their trades to third-party brokerages for execution. That’s because the latter firms often pay a small per-share fee to get such orders from other brokers.

Again, the issue is the quality of trade execution, and whether the customer gets the best possible buy or sell price.

“Maybe rather than making an independent best-execution evaluation, they [commission-free brokers] are directing it to the market makers who pay the highest payment for the order flow,” Unger said.

FinancialCafe.com’s Mansour, who acknowledged that the online brokerage sector is already crowded, said he views commission cost as just one component of the business.

“I think at the end of the day, service is what’s going to differentiate you from your competitors,” he said.