Boris Dus is the CEO and Founder of Gainy, a thematic autopilot investing platform for retail investors.
There’s been a lot of news recently about falling margins and cutoffs in financial startups like Robinhood, Mainstreet, Coinbase, etc. Business models of broker-dealer companies have changed significantly over time. Ten years ago, brokers made their money on trading commissions. With Robinhood changing the rules of the game, trading became “free.” In this article, I would like to examine how brokers make their money now.
Traditional Brokerage And Pay Per Transaction
The traditional brokerage business is about building a marketplace where buyers and sellers of securities are connected. In this case, a broker-dealer like Etrade or Robinhood executes transactions for a client and has access to the markets where these deals happen (NASDAQ
A broker receives the money directly from clients as a fee for an order they complete for them. Fees for retail investors are usually from 0.05% to 2%, depending on the capital volume and trading frequency. Usually, it was about $7 per transaction. This business model is virtually extinct in the U.S. market, where most large brokerage firms, from Robinhood to Fidelity, offer commission-free trading now.
At the beginning of the century, with the development of high-speed internet and technologies for financial markets, high-frequency trading came into play. In his book, Flash Boys: A Wall Street Revolt, Michael Lewis uncovered alleged front-running practices by some high-frequency trading (HFT) firms, including Citadel Securities. In 2020 FINRA announced penalties against Citadel Securities. They paid $700,000 in fines and made the clients whole, although without admission of any wrongdoing.
Despite the bad press, high-frequency trading and dark pools provide some important features for retail investors: faster deal execution, higher liquidity and tighter bid-ask spreads. The advance in high-frequency trading made a new business model possible—payment for order flow, the one that we know as “free” trading.
Commission-Free Trading Payment For Order Flow
High-frequency trading opened the gates for more creative business models, and one of the greatest examples is the Robinhood + Citadel Securities cooperation. They introduced commission-free trading with payment for order flow (PFOF). Most brokers like Robinhood and Fidelity don’t charge commissions directly from investors but split profits that market makers like Citadel Securities make when quoting bid-ask spreads.
By having the trade flows directed to them, market makers can better predict the trade volume and set bid-ask spreads more efficiently. Retail investors, as it happened before, pay a slightly higher price to buy securities than to sell them. In this sense, the spread is not new. However, PFOF allowed dropping commissions as the main source of income for brokers and made the trading sound more lucrative for retail investors.
To make the market even more attractive for small investors, brokers found a way to introduce fractional shares. Now instead of forking out over $2,000 for a share in Alphabet (GOOG), an investor can buy a fraction of a share for just a couple of dollars.
At some point, capital inflow slows down, so brokers need to come up with a way to increase return on capital. Margin trading is a logical step to achieving it. A broker loans funds to clients, which allows them to trade more. The more buying power, the more trades are made and the more PFOF brokers earn as an intermediary while also gaining interest on the loaned capital.
Every country has different regulations on how much margin a broker-dealer can provide clients with, and in the U.S., it’s about 50%.
Options And Other Complex Financial Products
With all the evolution we have described above, it’s clear that one day a brokerage company will reach the limit of capital that it can earn per client. Then, the question becomes, “How to increase the overall volume with the same amount of capital?”
And that’s when complex products like options come into play. Many derivatives have embedded leverage in them (option contracts usually represent 100 shares of the underlying stock). For many years, options and other derivatives were mostly hedge instruments for professional traders.
For retail, it became a promoted product on its own, with CNBC reporting that retail investors account for 25% of the total options trading volume, up 35% from 2021. On the one hand, instruments like that have higher volatility and allow retail investors to multiply capital much faster.
On the other hand, it drains the capital faster because of implied leverage and eventually reduces the commission that a brokerage company makes per transaction. It also requires clients to constantly follow the market and actively trade rather than invest. It is very time-consuming and complicated for most; otherwise, if they miss a beat, they might lose a lot of money on their open positions.
Charging For Advice—Not Trading
If a broker-dealer company is not actively trading but instead investing, it can charge for assets under management: Wealthfront, Acorns and Betterment use this model. In this case, clients are focused on mid-to-long-term goals that help to build wealth over time while having less aggressive but more steady returns. That’s why these companies charge a commission for capital allocation and management but not per transaction or other trading activities.
With this overview of the evolution of business models, I wanted to highlight the key differences and adoption of financial products and the companies standing behind them. Financial products are about building new business models and user acquisition channels that eliminate operation costs and boundaries on the money flow. Every aspect of a new financial product should be dedicated to the empowerment of newcomers and giving access to faster, more reliable and advanced “financial pipes” that speed up the financial flow.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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