No Such Thing as a Free Trade?

Some brokers think they've figured out a new way to grab market share in online trading -- giving away trades. Sound crazy? It might just be.

In the last month, two new free-trading sites have launched, while American Express(AXP Quote) has dished out free trades for more than six months.

But even if customers want to trade for free (and who wouldn't?), analysts question whether the concept works from a business point of view.

Free-trading sites generate revenue from payment for order flow, money that brokers get for sending orders to Nasdaq market makers, and margin interest income, the interest that brokers earn on money lent to customers. But both of those are under attack.

For brokers offering free trading, such as Ameritrade's(AMTD Quote) Freetrade.com, this means the strategy could end up being a money-losing proposition. For online traders, it could mean that they better take advantage of the free trades while they're around.

Brokerages like free trades because they believe the freebies give them a competitive advantage in an increasingly crowded field. American Express, for instance, says its brokerage business has taken off with its free-trading offer. It even had the longer customer service-telephone wait times earlier this year to prove it.

"We are acquiring a record number of accounts in terms of new numbers and assets," says Barry Murphy, an American Express Brokerage senior vice president. He declined to disclose figures.

But American Express doesn't have quite the same model as the two start-up brokerages. Amex requires account assets of at least $100,000, which enables it to earn interest on the cash balances in those fat accounts. It also funds its brokerage business the same way most brokerages do, with margin interest, commissions on paid trades and a little bit of payment for order flow.

Meanwhile, Freetrade.com and privately held Financial Cafe.com depend only on payment for order flow, margin interest income, commissions paid on other trades and possibly advertising or e-commerce revenue.

The problem is that payment for order flow rebates is increasingly controversial. The Securities and Exchange Commission is questioning whether brokers care more about the payments than sending the orders to market makers who guarantee the best trade executions for customers.

Payment for order flow exists because Nasdaq market makers make money off the difference between the bid and the offer on market orders, or orders to buy or sell stock at the market price. Therefore, market makers pay broker dealers like E*Trade (EGRP Quote) and Ameritrade for their market orders. Limit orders, or orders to buy or sell at a certain price, are less profitable for market makers, so in most cases market makers don't pay for them.

So it's no surprise that at both of these sites, only the market orders are free. Freetrade.com charges $5 for limit orders, and Financial Cafe.com charges $16.95 plus one cent a share.

Brokers offering free trades also need margin interest income. Margin interest income is the interest that brokerages earn on the loans they make to customers. But after hitting records heights in this year's first few months, margin debt backed off in March and April. And with stocks in decline, analysts expect that margin debt will continue to fall, eroding that as a revenue source.

"In my mind, the only way it [free trading] works is if you're making up the revenues somewhere else. So you have to ask the question, 'How are they making it up?' Payment for order flow and interest revenue," says Greg Smith, an analyst at Chase H&Q, which hasn't done any underwriting for Ameritrade.

"I don't see it as a long-term, sustainable business model," Smith adds. "I think people are willing to pay eight bucks, 15 bucks or 30 bucks to get the service they require."

Richard Repetto, an analyst at Lehman Brothers, worries that Freetrade.com will hurt Ameritrade's bottom line by siphoning away customers. According to his calculations, Freetrade would have to open two accounts to make up for every lost Ameritrade account. (Lehman hasn't done any underwriting for Ameritrade.)

Ameritrade declines to comment on its free-trading site.

How Ameritrade Can Make Up the $8 Commission It Loses With Free Trades
	Freetrade.com
Commission (50% free market orders and 50% limit orders at $5 a trade) revenue	$2.50
Payment for order flow	$1.70
Clearing and trade cost	($1.00)
Margin loan interest	$4.80
Advertising	0
Total	$8
Source: Lehman Brothers

Financial Cafe.com says it'll also generate revenue from assets under management, securities lending and e-commerce partnerships. The company also notes that it's managing costs.

"Costs are significantly below self-clearing," says Andrew Koslow, Financial Cafe.com's chief operating officer. Typically self-clearing -- or handling all the back-office operations in house -- is the lowest cost option to brokerages.

Ameritrade, which self-clears, is believed to have a cost per trade of under $1, including clearing, according to Repetto. "We don't have to pay for a lot of costs that other brokers do," Koslow continued.

At least one online broker is experimenting with free trades. Web Street (WEBS Quote) plans a free-trading day on May 30, but don't look for it to keep up the giveaways.

"We think we provide tremendous value for $14.95 and we have no immediate plans to change that," says Web Street President Joseph Barr. "To the extent that we are going to roll out significant value to them, that's a priority, as opposed to any desire to lower prices or go free."

Others aren't even entertaining the idea of giving away trades for a day. TD Waterhouse (TWE Quote), for one, sees no reason to vary from its current commission-based structure. TD Waterhouse, which added 418,000 accounts in the three months ended April 30, charges $12 for both market and limit orders.

Says CEO Stephen McDonald, "As an ongoing practice we don't think offering free trades is a sustainable economic model."