A discount broker is a slightly derogatoriy term for an (online) stockbroker who carries out buy and sell orders at reduced commission rates compared a full-service broker. Discount brokers are part of a broader development of heightened accessibility or “democratization” spawned by the disruptive force of networked technologies. Among other places, fintech has managed to move banking and financial transactions away from a few large scale players and distribute access more evenly. Before the emergence of better communications technology and with it the automation of stock trade execution, only the wealthy could afford a broker and access to the stock market. Discount brokers, which operate almost exclusively as online platforms, provide the portal to this electronic infrastructure at a fraction of the cost of a traditional broker and allow individuals with smaller capital to trade for low to no fees and with less capital.
Discount brokers carry out orders at less cost, but they typically just execute orders for their clients. These brokers do not offer personal consultations, advice, research, tax planning, and estate planning services for customers. Operating their businesses online only allows them to reduce additional overhead costs. The services provided by discount brokers are aimed at self-directed traders and investors, and the electronic trading platforms are built in a way that is beneficial for active traders with charting and position monitoring services. Because they are low-cost, online, easy to operate (sometimes only via a smart phone app), and tailored to reduce complexity, discount brokers attract a lot of young investors, often with little to no experience and education in the financial markets.
Here lies one of the chief criticisms discount brokers have been confronted with: Their margins are higher the more their clients trade, so there may be a conflict of interest where the discount brokers incentivize their clients to frequently trade. However, this may not necessarily be for the benefit of the clients, as low-risk “buy and hold”-strategies have been proven to be most successful for less experienced investors. The brokers’ margins are even higher if their users trade with leveraged derivative products, such as options. However, these products are considerably riskier than simple stock investing.
Discount brokers’ actual business model may vary from what they are generally perceived of doing. They do not have fiduciary responsibilities, which means that they do not have to put their users’ needs ahead of their own and therefore have no obligation to know your risk tolerance, goals and other financial information before making recommendations.
As discount brokers essentially only act as intermediaries in the process of financial transaction forwarding stock orders to actual market makers, they make large profits by the controversial practice of order flow directing, i.e. assigning which market maker may execute which order. This is a way to profit off of their customers’ orders which may or may not be noticed by the users.
Due to their cost-saving infrastructure, discount brokers have been frequently reported having issues in regards to reliability, reachability and availability of certain securities.
Orders may not be executed, the brokers’ website and customer accounts may be down unpredictably (in March of 2020 alone, there were 21 outages reported with discount broker Robinhood, one of which lasting more than a day), or certain securities may be banned from trading alltogether, as was temporarily the case with GameStop’s stock during the short squeeze, the latter even leading to a class-action law suit for market manipulation against discount broker Robinhood.
This can put discount brokers’ clients at a serious disadvantage, of course, e.g. if due to one of the above-mentioned scenarios they are not able to close a position in time that is rapidly losing value or purchase stock that is rapidly gaining value.