Introduction
In 2021, one of the top trading brokerages, Robinhood, recorded a rise in its transaction-based revenue.
The recorded rise was at 12.2% and translated as $362.7 million in the fourth quarter (Q4) of the financial year (FY) of 2021. It accounted for nearly 73% of Robinhood’s entire revenue.
Robinhood’s main competitors, such as E*TRADE Financial Holdings LLC and many others, recorded the same growth in profit or, at least, come close.
If you are wondering whether trading brokerages generate hefty revenues, well, they do.
Like any other business in operation, they also aim to gain profits in their daily dealings.
So, whether you intend to start your brokerage business or you only want to know how brokerages earn, this article will expose the facts surrounding brokerages and how they manage to stay afloat.
What is a Brokerage Firm?
In this article, we will refer exclusively to brokerage firms that specialize in financial products such as stocks, bonds, cryptocurrency, commodities, etc.
They are otherwise referred to as Brokerage Companies or simply Brokerages.
A brokerage firm acts as a middleman who connects buyers and sellers of financial products enabling them to trade.
A brokerage firm is a platform that facilitates the buying and selling of financial assets such as stocks, bonds, options, commodities, and, increasingly, cryptocurrencies by its clients.
With technological advancements, brokerages operate using electronic platforms to facilitate the exchange of financial products.
Brokerages typically receive compensation through commissions or fees charged once the transaction gets completed.
Nowadays, these fees or commissions might be paid by the exchange or by the customer; in some cases, both parties may pay the fees or commission.
Why brokerage companies are important
Brokerage firms fill numerous gaps separating sellers and buyers of financial products.
It is so because the perfect market does not exist where everybody has access to complete market information.
Buyers don’t have up-to-date information at all times about the best prices and product availability, as well as seller information and availability.
Likewise, sellers lack these details about potential buyers, that is, precisely, where brokerages come in.
Hence, brokerage firms help to seek out and then match both sides to each other. By doing so, they are paid a commission for their services.
How brokerages earn money
Brokerages, typically, use any or all of these means to generate income which is key to their survival:
- Deposit fees
- Withdrawal fees
- Inactivity fees
- Spread or mark-up prices
- Interest fees
- Payment-for-order-flow (PFOF)
We have outlined each of them in detail below.
1. Deposit fees
The vast majority of brokerages charge for deposits made by their clients into their accounts.
To trade stocks, forex, crypto, bonds and the likes, you have to open a trading account with a brokerage.
To buy your desired product, you must fund that account through a bank transfer, a credit card, a debit card or whatever method is allowed.
Funding the trading account means that you’ve deposited into the account.
For that action, brokerages would charge a certain fee.
2. Withdrawal fees
Like deposits, fees may apply in withdrawals from your trading account with a brokerage.
When you sell any financial asset, you will receive payment into the trading account you are operating with a brokerage.
Such payments would keep accumulating in your account until you decide to withdraw your trade proceeds.
Withdrawal typically means that you would transfer the proceeds from your brokerage account into your bank account.
Doing so could attract a special fee by the brokerage firm known as the withdrawal fee.
3. Inactivity fees
The inactivity fee is designed to motivate the traders (clients) to keep their accounts active.
The whole point is to make the trader more engaged and, therefore, trade as much as possible.
This is not without its reason because high trade volume on the brokerage’s platform attracts revenue for the firm.
So, if you have a trading account that stays dormant for a certain period, the brokerage firm might charge inactivity fees.
Although not all brokerages charge this fee, it is necessary to find out if a brokerage charges the fee, and if so, find out how much.
4. Spread or mark-up prices
The term ‘Spread’ means the difference between the buy and sell prices.
What brokerages do is that they offer you an asset. E.g. a currency pair in forex trading to buy at a slightly higher price than the actual price.
Equally, they offer to sell for you at a slightly lower price than the actual price, though it may seem like a good deal to you.
It’s for this reason that trades usually open in negative because the brokerage already marked up the price at the beginning of your trade.
5. Interest fees
Brokerages also earn when you trade on margin, otherwise known as leveraged trading.
Margin trading means using borrowed funds from your brokerage to trade bigger than you can afford.
When you borrow from a brokerage to fund your trading, the brokerage generates interest revenue.
In the fourth quarter (Q4) of the 2021 financial year (FY), interest on borrowed funds amounted to $63.7 million in revenue for Robinhood.
6. Payment-for-order-flow (PFOF)
Payment-for-order-flow (PFOF) comes in as the most important means through which brokerage firms earn their income.
PFOF simply means that the brokerage gets paid for channelling its investors’ orders for cryptocurrency, stocks, futures, commodities. Etc. to market makers.
To break it down further, when an investor places an order for any financial asset, the brokerage processes the order and passes it to a wholesaler of the asset, a market maker.
The market maker then carries out the purchase or sale order given through the brokerage by the investor.
For routing the sale or buy order to the market maker, the brokerage gets rewarded with a small payment, hence, payment-for-order-flow.
Usually, in a trade, the client gives the brokerage an ask price (the price he’s willing to pay for an asset).
The brokerage passes it to a market maker who then locates and executes on the best price available, known as the bid spread.
If the market maker buys the asset at a lower price than the client asked for, the surplus, called the bid-ask spread, is split between the market maker and the brokerage.
The profit-sharing of this scheme is built into the bid-ask spread.
PFOF is the most popular means that brokerage firms use in earning revenue for themselves. It usually amounts to around 70% of revenues generated by brokerages.
Conclusion
If you’ve been wondering how brokerage firms make their money, well, there you have it.
There may be more, but the ones we’ve outlined are the most common among brokerages.
Money is oxygen to businesses, and brokerages aren’t an exception; they need it to stay afloat, so they use these means to earn.
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