JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL. 18, NO. 3. SEPTEMBER 1983

Negotiated Brokerage Commissionsand the Individual Investor

Gerald A. Blum and Wilbur G. Lewellen*

The elimination in 1975 of fixed minimum brokerage commission rates foragency transactions in equity securities was one of the more highly publicizedevents in the still-ongoing process of the deregulation of American financial mar-kets. While, prior to that time, commission rates on large stock transactions—that were executed primarily for institutions—had become increasingly subjectto negotiation, individual investors effectively faced an industry-wide fixed priceschedule for the vast majority of their transactions. At the insistence of the Secu-rities and Exchange Commission, the privilege of negotiation on commissionrates was extended to securities trades of all sizes as of May 1, 1975, a date thebrokerage industry only half-humorously dubbed ' 'Mayday'',

Since then, some of the anticipated shake-out in the industry has occurred asweaker firms have been absorbed by their stronger competitors, and a new classof "discount" brokerage houses offering little more than order execution ser-vices at commission rates well below those posted by the full-service retail firmshas grown up (see [5], [6], and [13]). The latter have not, however, disappeared.Presumably, this is because individual investors either continue to value the re-search and other services they acquire with their higher commission rates, orbecause those rates indeed are often negotiated downward in practice at full-ser-vice houses. Our focus here is on the second of these two phenomena.

Specifically, we shall examine the frequency, magnitude, and correlates ofthe discounts from scheduled commission rates obtained by a large sample ofindividual investors during the 1970s, We find that such discounts from postedrates did become fairly common, that they increased in size over time, and thatthey were related to certain distinctive characteristics of both the investors andthe securities transactions involved in a manner that seems plausible. Nonethe-

• Babson College and Purdue University, respectively. This study comprises a portion of theNational Bureau of Economic Research program of research in Financial Markets and Monetary Eco-^Q^Tc on ' "PP"" ^° ' ""^ "" ' 'y f'""" "'^ National Science Foundation under Grant No SOC-7825789 IS gratefully acknowledged. Any opinions, findings, and conclusions or recommendationsexpressed are those of the authors, and do not necessarily reflect the views either of the NationalScience Foundation or of the National Bureau of Economic Research. The authors acknowledge-without imputing culpability—the advice and suggestions of K. Rao Kadiyala, Gary G. SchlarbaumKeith V. Smith, and Gordon P. Wright.

331

less, they were not sufficient to offset fully the appearance of a general trendsince Mayday for small investors' commission costs to rise, at least at full-ser-vice brokers [12].

I. The DataThe transactions studied are those that were executed by one of the nation's

largest retail brokerage firms on behalf of its customers between May 1, 1975and the end of September 1979. The accounts involved are those of mdividualinvestors- corporate, institutional, and investment club accounts were excludedfrom consideration. The sample selected has three components. The first compo-nent was chosen randomly from a list of the firm's customers who had aecountsopen eontinuously over the period January 1, 1964 through December 31, 1970.This group comprised the sample that was developed for an earlier study of mdi-vidual investor behavior [2], [3], and data for transactions on the aecounts thatremained open were compiled through 1979 for the current investigation.

The seeond component consists of a similar, new random sample drawnfrom the list of accounts that were in eontinuous existence from January 1, 1971through September 30, 1979. This sample was obtained to be the focus of anupdate and expansion of the analyses performed on its predecessor. In both in-stances, a requirement of account longevity was imposed to permit longitudinalstudies of investment performance and behavior to be undertaken [4], [11]. Norestrictions or minimum conditions on either trading frequency or portfolio sizewere applied as seleetion criteria, however; both samples are quite diverse alongthese dimensions. In total, the two groups include approximately 6,000 mdividu-

alsThe third component, chosen as a control, was drawn at random from all the

accounts that were open with the firm at some time between January 1971 andSeptember 1979, regardless of duration. The control group contains just over2 000 individuals. For all three groups, a complete record for 1971-1979 of thetrading activity in the account was furnished by the cooperating brokerage house.Those transactions that occurred beginning on May 1, 1975 are our present con-

Trades executed by the firm on a principal basis, and ones not involvingcommon stocks, were culled from the file. The resulting data base eneompasses93 528 agency transactions in equity securities, the salient features of which areportrayed in Table 1. As is evident, transactions over a wide range of sizes areincluded, with ample representation at all levels. While trades on the New YorkStock Exchange comprise the majority, some 40 percent involved securitieslisted on the American or one of the regional exchanges, or traded in the UlCmarket The transactions are divided approximately evenly between purchasesand sales with round-lot orders predominant. Just 50 percent were executed foreustomers who maintained a margin account.' For all transactions, the brokeragecommissions actually paid by the customer were recorded. These were compared

1 This does not necessarily imply that every trade in such an account was margined, however.The transactions file does not contain that information on a trade-by-trade basis.

332

with the charges in the firm's posted rate schedules to determine whether com-mission discounts were obtained.

TABLE 1

Characteristics of the Transactions Data Base: 1975-1979(N = 93,528)

Type of Trade

PurchaseSale

QuantityRound LotOdd Lot

Account TypeMarginCash

49%51

85%15

45%55

Trading LocaleNYSEAMEXOTCRegionai

Transaction Size*Under$2000$2000-84999$5000-39999$10,000-$24,999$25,000-$49,999$50,000 and over

61%135

21

36%32181031

*Per-share price times number of shares traded. Exoludes commission charges

An issue of concern with regard to the generalizability of our findings is theextent to which the observed experience of the customers of the particular firmthat supplied the data analyzed here can be considered representative. We believeso, for several reasons—among them, the mandates of competition. The firm haslong been, and still continues to be, among the nation's ten largest full-servicebrokerage houses. It has primarily a retail orientation, and has managed success-fully to grow and remain profitable in the rapidly changing environment of thelast decade. Our assumption is that this would not have occurred had the firm notsustained a competitive array of investment products and prices. If there werepressures in the post-Mayday market to provide commission discounts, the firminevitably would have felt them in the same way as other full-service brokeragehouses.

Second, in earlier studies, the firm's customer base was found to exhibitdemographic characteristics that in all major dimensions were a virtual duplicateof those of the total U.S. shareholder population (see [2], [8], and [9]). Onemight, therefore, expect that the degree of interest in, and insistence upon, ob-taining commission discounts from the firm also would be decently characteristicof that broader shareholder population. Finally, the posted commission rateschedules of the firm, over the time period investigated, were quite consistentwith those of other major full-service brokerage houses [12]. Hence, the bench-marks from which any discounts we observe would have been offered were stan-dard for the industry. For three reasons, then, we have confidence that the rela-tionship between the firm and its customers captured by our data is likely to be arespectably representative one.

The nature of the rate schedules in question merits some brief attention.

333

Underlying the charge quoted for any given transaction was a set of formulas thatspecified the percentage commission rates to be imposed on trades of succes-sively larger volumes; different such percentages applied to securities in differentper-share price ranges. In addition, distinctions were made between round- andodd-lot trades, and various mandated minimum and maximum charges as over-rides to the formulas.

The net result was commission schedules that had the general (and logieal,assuming that order execution costs have an inherent fixed component [7]) char-acter that the percentage rates quoted diminished with increasing dollar ordersize. Three other points are worth noting: (1) the same posted rates applied toboth purchase and sale transactions; (2) the rates were the same for listed andOTC stocks; but (3) the rates were raised sequentially over time after Mayday inthree steps. Each such change increased the quoted commission rates for virtu-ally all transactions (there were no reductions), and the secular increase was no-ticeably greater for small trades.

II. Methodology and HypothesesUsing standard linear regression, cross-classification, and discriminant

analysis techniques, we tested the data for the presence of statistically significantrelationships between the percentage discounts (if any) from concurrent postedcommission rates offered by the firm on each of the 93,528 common stock tradesin our data base, and a set of independent variables that characterized the transac-tion and the customer involved. Thus, the dependent variable was defined as (Cj- Cf,)ICs, where Cj is the dollar amount of the scheduled commission for thetrade and C^ is the actual commission paid, as recorded in the transaction file.The independent variables encompass both categorical and cardinal attributes ofthe trade and the customer account.

Included among the former are: (1) whether the transaction was for a round-or an odd-lot number of shares; (2) whether it was a purchase or a sale; (3) thecommission schedule in force at the time; (4) whether the transaction occurred ina cash or margin account; and (5) whether it was undertaken at the suggestion ofthe firm's account executive ("solicited") or initiated by the customer ("unsoli-cited"); each trade in the file carried such a tag.

The cardinal attributes examined include the dollar size of the transaction(price per share times number of shares) and two indices of the level of tradingactivity in the account in question: the dollar volume of eommon stock transac-tions executed in the account during the year immediately preceding the observedtrade, and the aggregate commission revenue to the firm generated by the ae-count over the same period. For a transaction that occurred on Oetober 1, 1978,therefore, both trading volume and commission revenues in the associated ac-count for the interval October 1, 1977 through September 30, 1978 weresummed and attached to the transaction as customer "attributes." Since pressreports [ 1 ] suggest that it is the pace of annual trading activity by a customer thatis the primary determinant of full-service houses' willingness to contemplate of-fering a commission discount, the two measures indicated seem reasonable onesfor our purposes here. Because they inevitably will be highly correlated across

334

accounts, they were, of course, employed as alternative rather than coincidentindependent variables in the statistical tests.^

Our hypothesis was that the size and frequency of observed commissiondiscounts would turn out to be directly related to the level of activity in the sam-pled accounts. We also expected to find that discounts became larger and morefrequent over time, both because of growing competitive pressures from discountbrokers and because the secular increase in posted commission rates imbedded inthe succession of such schedules provided a steadily larger "umbrella" underwhich to offer discounts. We further anticipated a positive relationship betweenthe size of the individual transaction observed and the frequency of discounting,on the suspicion that the formal quoted rate schedules, even after Mayday, werenot in fact "tilted" sufficiently to reflect fully brokerage firms' internal econo-mies of scale in order execution. A coincident pattern of more frequent discountson round-lot orders was expected as well, for similar reasons. Finally, we pre-dicted that customers having margin accounts would obtain discounts more oftenthan those with cash accounts by the logic that they may be characterized as more"sophisticated" and, therefore, more apt to attempt to negotiate on charges. Thelikely influence of the other identifiable attributes of the sampled transactions,however (whether the trade involved was a purchase or a sale and whether theorder was solicited or unsolicited), was less clear to us on an a priori basis.

III. The Discount Profile

Some insight into these phenomena, and into the overall commission dis-count policy of a full-service brokerage house, can be gained from the frequencydistributions arrayed in Table 2. Evidently, discounting did occur more than oc-casionally: fully one-fourth of the post-Mayday trades observed were chargedcommissions at below-posted-schedule rates. The incidence rose from 20 percentin the immediate post-Mayday period (when commission Schedule #1 was inforce) to 34 percent by 1979 (Schedule #3). The frequency of large discounts(30 percent or more) roughly doubled over that same time span.^

Conditioned by press reports suggesting that most full-service brokers arenot very forthcoming in either advertising the availability of or actually offeringdiscounts (see [1], [6], and [10]), we were surprised to find them occurring sooften in our data. A word of caution, however, is in order. Our sample of ac-counts contains a relatively high proportion of longtime customers of the firm. Itmay be the case that such individuals were able to obtain commission reductionsat above-normal success rates, merely by virtue of the longevity of their relation-

2 The independent variable we would really like to have, obviously, is one that indicateswhether the customer actually asked for a discount on a particular trade. Regrettably, those data areunavailable in the transaction file.

^ Because the firm did some rounding of its commission charges to even dollar amounts formany trades—and because some data entry errors inevitably would have occurred in recording thecommission figures on the file—any observed discount of less than 5 percent was assumed to reflectone of these phenomena, and was treated as belonging in the "no discount" category. It is difficult tobelieve, for example, that a recorded commission of $185 for a transaction that should carry a $186charge according to the posted rate schedule really represents the results of negotiation. Approxi-mately 2 percent of the trades in the data file were reclassified in this manner.

335

TABLE 2The Commission Discount Profile: 1975-1979

TransactionCategory

A. All Post-Mayday Trades

None

75%

B. Applicable Commission Schedule:#1 (Early)#2 (Middle)#3 (Late)

C. Order Size;Under $2000$2000-$4999$5000-$9999$10,00Q-$24,999$25,000-$49,999$50,000 and over

80%7766

84%7871603614

Commission Discount as a Percentof Scheduled Commission Rate:

< 15%

8%

8%79

5%9

1011118

D. Annual Account Trading Volume (Preceding Year):Under $25,000$25,000-399,999$100,000-$249,999$250,000 and over

E. Order Quantity:Round LotOdd Lot

F. Order Type:PurchaseSale

G. Account Type:CashMargin

H. Order Origin:SolicitedUnsolicited

85%534729

74%78

78%72

74%76

75%75

6%151219

8%5

8%8

7%9

8%8

15%-30%

7%

5%6

11

5%69

111623

5%141422

8%7

7%8

8%6

8%6

30%-50%

6%

4%68

4%56

101830

3%111514

6%6

4%8

7%6

6%7

> 50%

4%

3%45

2%248

1925

1%7

1216

4%4

3%4

4%3

3%4

336

ships. Hence, there may be something of an upward bias in the count within thesample. On the other iiand, this should not affect the cross-sectional discountprofile as it is influenced by other attributes of the customer or the transaction.From Table 2, it is apparent that influences of this sort were present, prominentamong them the indicated secular growth in discount size and frequency.

Consistent with expectations, both the dollar amount of the trade executedand the level of trading activity in the account of the customer who placed theorder display a strong positive relationship to the magnitude of the commissiondiscount obtained. Whereas discounts were provided on only 16 percent of small(under $2,000) orders, they occurred in 86 percent of the cases involving tradesof more than $50,000, and the majority of the latter were in excess of 30 percentoff scheduled rates. Similarly, individuals whose annual trading volume was lessthan $25,000 realized discounts on approximately one-seventh of their trades,these being generally small reductions. Customers who traded more than a quar-ter million dollars' worth of common stock annually, however, paid below-schedule commission rates on nearly three of every four transactions, and lessthan half the scheduled rate about one time in six. Crude as our volume measureis, the findings are striking.'' A formal cross-classification analysis of the data,arrayed by the discount percentage categories shown in Table 2, and then byapplicable commission schedule, by transaction size, and by account activitylevel, yielded chi-square statistics in all three instances that implied departuresfrom the total sample discount distribution at well beyond the 99 percent confi-dence level.

In fact, because of the very large sample size with which we are dealing,commensurate levels of statistical significance were indicated by cross-classifica-tion analyses of the discount percentage groupings against the other four categor-ical attribute variables listed in Table 2 as well—although, clearly, the opera-tional significance of those relationships is much more modest. We observe atendency for discounts to be only slightly more prevalent on round-lot than onodd-lot orders. Presumably, this is a reflection of the fact that the predominantinfluence on the availability of a commission discount is account activity (seebelow) and it so happens, as a separate cross-tabulation reveals, that even high-volume customers engaged in odd-lot transactions during the time period studiedwith a frequency not much different from the sample as a whole.

There is a stronger suggestion that discounts were obtained more often andin larger amounts on sale transactions than on purchases. While we had no de-veloped hypothesis in this regard, we can propose some possible explanations.On occasion, there may have been an understanding between the customer andthe account executive, at the time a security purchase order was entered, that adiscount would be made available when and if the other end of the investment"round trip" was also executed through the firm. In another instance, a discounton a sell order might be offered as an inducement and encouragement to thecustomer to place his or her next purchase order with the firm. These are onlyspeculations, however.

"• A similar profile also emerged when trades were categorized by the level of the precedingyear's commission revenues generated by the account.

337

The discount differentials are similarly undramatic when the sampled trans-actions are divided according to whether they occurred in a cash or a marginaccount, and whether the order in question was solicited or unsolicited. To theextent that a pattern can be discerned, it is in a direction counter to what weexpected to observe. In particular, cash-account customers seem to have donebetter at obtaining discounts than individuals with margin accounts, despite ourperception of the latter group as more negotiation-prone. Conceivably, such cus-tomers may instead see themselves as consuming the full range of the firm's ser-vices and, therefore, more willing to pay full price; the firm may have a commen-surate attitude on the other side of the bargain. By similar reasoning, the slightlysmaller incidence of large discounts on solicited orders than on unsolicited onesmay reflect the larger service component of the former, i.e., the account execu-tive's time and effort in calling the investment opportunity to the customer's at-tention.

IV. Multivariate Analyses

The most substantial influences on commission discount availability andsize appear to be account activity, the magnitude of the trade, and the postedcommission schedule in force—the last of these effectively being a time proxy.This inference is supported by a stepwise multiple regression analysis of the data,wherein the percentage commission discount obtained is the dependent variableand the various transaction attributes listed in Table 2 are the independent vari-ables. The results are as follows:

CoefficientStep

VariableEntered Sign

Past Year's TracJing Volume {$)Transaction Size ($)Commission Schedule #3 (= 1)Margin Account ( = 1)Purchase Order ( = 1)Solicited Order ( = 1)Commission Schedule #2 (= 1)Round-Lot Order ( = 1)

All coefficients were significant at the 99 percent confidence level or better(again, a virtually inevitable consequence of a very large sample size). All had asign consistent with the messages of Table 2, and the entry order of the variablesaccords well with those same messages,^

While the overall explanatory power of the regression equation was rela-tively modest yielding an R^ of 18 percent, this could be anticipated given thatapproximately 75 percent of the observations on the dependent variable had avalue of zero. More importantly, 60 percent of that explained variance was ac-

5 Commission Schedule # I was omitted as an independent variable, to avoid overspecifying therelationship.

338

eounted for by the first independent variable entered (annual customer tradingvolume), and fully 91 percent by the first three. Clearly, the remaining attributeswere of minor consequenee.*

Comparable results were obtained when the alternative measure of accountactivity noted above—commission revenues generated by the customer duringthe year preceding a trade—was substituted for trading volume as a eandidateindependent variable. The stepwise entry and coefficient profile are as follows:

Variable CoefficientStep Entered Sign

1 Transaction Size ($) -t-2 Past Year's Commissions ($) +3 Commission Schedule #3 ( = 1) -i-4 Margin Account ( = 1) -5 Purchase Order ( = 1) -6 Commission Schedule #2 ( = 1) +7 Round-Lot Order (=1) +8 Soiicited Order ( = 1)

Again, all coefficients were statistically significant at the 99 percent level, withthe first three variables entered contributing 88 percent of the total explainedvariance. In this formulation, however, the R^ declines by one-third and the re-vised aetivity measure falls to second place in the entry sequence. It appears,therefore, that a customer's annual trading volume is a better indicator of thecommission discount than is the level of past commissions paid. This seems logi-cal since the diseounts that were obtained on previous trades by high-volumecustomers would effeetively introduce some noise into the past-commission fig-ures recorded for them.^

Finally, the transactions were divided into two groups—trades on which adiscount was received and those on which the full scheduled eommission ratewas paid—and a stepwise multiple discriminant analysis was performed to iden-tify the correlates of group membership. The findings shown in Table 3 reinforcethe regression results. Account activity, trade size, and the dummy variable forcommission Schedule #3 are entered in the first three steps. They display Fvalues and standardized discriminant function coefficients well in excess of thoseof the other candidate variables, and they are the only variables for which thedifferences in group means are at all substantial. Table 3 indicates that the typicalcustomer who obtained a eommission discount (which averaged 30 percent) hadannual trading volume of over $230,000 and a mean individual trade of some

*> Collinearity among the independent variables did not pose a problem. The highest simple cor-relation coefficient between any two independent variables was 0.233, and most were in the range of-O . l t o -1-0.1.

' As supplementary analyses, the transactions data were also stratified by stock-price categories(e.g., trades in stocks selling within a quarter point of $10, $20, $30, etc.) and regression equationestimates obtained for each such category. The results were consistent throughout: account activity,trade size, and the commission schedule regime were the dominant explanatory variables; and theequation fits were better when past trading volume rather than past commission revenue was used asthe activity measure.

339

$11,000; the corresponding figures for the full-rate payers were approximately$70,000 and $4,000, respectively.

V. The De Facto Commission Profile

On that basis and as a device to summarize our findings, the relationshipsbetween the actual per-share commission charges paid hy high-volume and low-volume customers, and the scheduled rates posted hy the cooperating brokeragefirm during the period studied, are recorded in Table 4 for certain benchmarktransactions. For the analysis here, the commission charges recorded in the trans-actions file for all trades in stocks selling within one-quarter point of $10 and $50at the time of the trades were averaged and converted to percentage figures. Thiswas done separately for each of the three commission-schedule regimes and,within each, for trades of 100, 300, and 500 shares. The results for other stock-price categories were consistent with those portrayed. Transactions involvinglow-volume customers were defined (pursuant to the message of Table 3) asthose occurring in accounts in which trades totaling less than $100,000 had beenexecuted during the prceding year; if the total exceeded $100,000, the transac-tion was assigned to the high-volume group.

The pattern is clear. For trades in low-price stocks, both scheduled and ac-tual percentage brokerage commission charges increased for customers with lowlevels of trading activity, despite a certain degree of discounting after Mayday.For transactions in higher-priced securities, the same individuals experienced ei-ther only modest increases or held their own. High-volume traders, on the otherhand, appear to have enjoyed commission rate reductions across the board, inamounts that by the end of the period under investigation were quite sizeable.^Thus, there was a noticeable change over that period in the tilt of the de factocommission profile. The evidence is strong enough to suggest that the trend willcontinue.

8 As one of the paper's referees pointed out, however, if the indicated commission rates areindexed by the roughly 8 percent per annum inflation rate experienced during the same years, the realrate charged actually declined for all transactions.

340

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TABLE 4

Selected Comparisons of Scheduled and ActualBrokerage Commission Rates: 1975-1979

(Expressed as a Percentage of Order Size)

A. For Stocks Selling at $10 Per Share

Commission (%)

OrderSize

Scheduled Rates100 Shares300 Shares500 Shares

Pre-M ay day

2.8%2.52.1

Paid by Low-Volume Customers100 Shares300 Shares500 Shares

2.8%2.52.1

Paid by High-Volume Customers100 Shares.300 Shares500 Shares

OrderSize

Scheduled Rates100 Shares300 Shares500 Shares

2.8%2.52.1

Schedule#1

3.0%2.72.3

3.0%2.62.2

2.4%2.01.7

Schedule#2

3.2%2.82.5

3.2%2.62.3

2.4%2.01.7

B. Eor Stocks Selling at $50 Per Share

Pre-Mayday

1.4%1.41.3

Paid by Low-Volume Customers100 Shares300 Shares500 Shares

1.4%1.41.3

Paid by High-Volume Customers100 Shares300 Shares500 Shares

1.4%1.41.3

Commission (%)

Scheduie#1

1.6%1.41.3

1.6%1.41.3

1.3%1.11.0

Schedule#2

1.7%1.51.4

1.7%1.41.3

1.2%1.00.9

Schedule#3

3.3%3.02.6

3.3%2.82.4

2.0%1.81.5

Schedule#3

1.7%1.51.4

1.7%1.41.3

1.0%•0.9

0.8

342

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[4]

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[10]

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343