Few traders take the time to understand where their money goes when they open a position with their broker, and how much it really costs. Keep reading to find out how trading brokers make money.
Ever wondered how those fancy brokerage firms stay afloat when they’re offering “free trades” left and right? I’ve been investing for years and always found myself scratching my head about this exact question, Let’s dive deep into the money-making tactics of brokers and what it means for your wallet
The Basics: How Brokers Earn Their Keep
Brokers are essentially middlemen in the financial world. They connect buyers with sellers in various markets and take a cut for their services. But the ways they make money have evolved dramatically in recent years, especially with the rise of discount brokerages and online platforms.
Commission and Fee Structures
Traditionally brokers made their money through straightforward commissions. Every time you bought or sold a stock you paid them for the privilege. But nowadays, the revenue streams are more diverse
- Transaction fees and commissions: Though many online brokers now offer “zero-commission” stock trades, they still charge for other types of transactions
- Wrap fees: All-inclusive annual charges (typically 1% to 3% of assets under management)
- Account maintenance fees: Regular charges just for having an account
- Premium service fees: Charges for additional features or personalized service
- Margin interest: Interest charged when investors borrow money to trade
Different Types of Brokerages and Their Revenue Models
The brokerage landscape has several distinct categories, each with their own approach to making money:
Full-Service Brokerages
These traditional brokers offer comprehensive services including:
- Financial planning
- Estate planning
- Tax advice
- Personalized investment consultation
- Market analysis and research
Full-service brokers like Merrill Lynch, Morgan Stanley, and Edward Jones typically earn money through:
- Wrap fees (1-3% of assets annually)
- Trading commissions (though competitive pressures have pushed many to reduce these)
- Service fees for specialized assistance
These firms usually target affluent clients and often require minimum account balances of six figures or more.
Discount Brokerages
Online discount brokers revolutionized the industry by drastically cutting costs. Companies like Charles Schwab (which pioneered the model in 1996), Fidelity, and Interactive Brokers make money through:
- Fees for premium services
- Payment for order flow (selling client orders to market makers)
- Interest on cash balances
- Margin lending
- Foreign exchange fees
While basic stock trades are often free, these brokers charge for other services and have developed tiered pricing models with premium options.
Robo-Advisors
The newest kids on the block, robo-advisors use algorithms to manage investments automatically. Their revenue model typically includes
- Management fees (usually 0.25% to 0.50% of assets under management)
- Premium service upgrades
- Interest on cash balances
These platforms typically have very low entry requirements and minimal fees compared to traditional brokers.
The Hidden Revenue Streams of “Free” Brokerages
When something’s free, YOU are often the product. This is especially true with discount brokerages that advertise commission-free trading. Here’s how they actually make money:
Payment for Order Flow (PFOF)
This is a biggie that most investors don’t understand. When you place a “free” trade, your broker might be selling that order to a market maker who executes it. The market maker pays the broker for this privilege, creating a revenue stream.
The controversy? There’s potential for conflict of interest here, as your broker might route orders to whoever pays them the most rather than whoever gives you the best execution price.
Interest on Cash Balances
When you deposit money into your brokerage account and it sits uninvested, the broker can use that money to earn interest. They’ll pay you a tiny fraction of what they earn and pocket the difference.
For example, if a broker earns 4% on your cash but only pays you 0.01%, they’re making a tidy profit on your idle funds.
Margin Lending
Brokers LOVE when you trade on margin (borrowing money to invest). Interest rates on margin loans typically range from 7% to 12% or more – a highly profitable revenue stream for brokerages.
Selling Premium Services
Many discount brokers use a “freemium” model – basic services are free, but advanced features, data, research, and tools cost extra. It’s like getting a basic car for free but paying extra for air conditioning, power windows, and leather seats.
Independent vs. Captive Brokerages: Following the Money
Another important distinction in the brokerage world is between independent and captive brokers:
Independent Brokerages
These brokers aren’t tied to specific product providers and can offer a wider range of investment options. Registered investment advisors (RIAs) fall into this category and are held to a fiduciary standard, meaning they must act in the client’s best interest.
They typically earn money through:
- Advisory fees
- Commissions on recommended products
- Fee-for-service arrangements
Captive Brokerages
Captive brokers are affiliated with or directly employed by specific companies (like insurance firms or mutual fund companies). They can only sell their employer’s products, which creates obvious limitations for clients.
Their revenue comes from:
- Commissions on product sales
- Salaries from their employer
- Performance bonuses
The key difference? Independent brokers have more flexibility to recommend truly suitable products, while captive brokers might be incentivized to push particular offerings regardless of whether they’re the absolute best fit for you.
The Fiduciary Standard vs. Suitability Standard
One crucial factor that affects how brokers make money is the standard they’re held to:
- Fiduciary standard: Requires brokers to act in the client’s best interest (independent advisors typically follow this)
- Suitability standard: Only requires recommendations to be “suitable” for the client, not necessarily optimal (many captive brokers follow this lower standard)
This distinction matters because brokers working under the suitability standard might recommend products that pay them higher commissions even if there are better options for you elsewhere.
Retirement Security Rule: New Changes Coming
The Department of Labor recently issued a new Retirement Security Rule (effective September 23, 2024) that impacts how brokers can make money when dealing with retirement accounts.
This rule aims to protect investors from conflicts of interest by holding more advisors to the fiduciary standard when providing retirement investment advice. It’s an attempt to ensure that advisors aren’t recommending products solely because they pay higher commissions.
How to Choose the Right Broker for Your Needs
Understanding how brokers make money can help you choose the right one for your situation:
If you’re a confident investor who doesn’t need much guidance:
- A discount broker with low or no fees for the services you use most frequently
- Watch out for hidden fees on services you might occasionally need
If you need comprehensive financial planning and personalized advice:
- A full-service broker might be worth the higher fees
- Carefully evaluate whether their services justify the 1-3% of assets they typically charge
If you’re somewhere in between:
- Consider a hybrid model or tiered service
- Look for transparent fee structures
Final Thoughts: Knowing Who’s Getting Paid and How
In my years of investing, I’ve learned that understanding how brokers make their money is essential to being a smart investor. When someone offers you something “free,” always look for where the cost is hidden.
Remember:
- No broker provides truly free services – they’re just making money in less obvious ways
- The broker with the lowest advertised fees isn’t always the cheapest overall
- Consider the value you receive relative to what you pay
- Always ask direct questions about ALL potential fees and revenue sources
By understanding the various ways brokers generate revenue, you can make more informed decisions about who handles your investments and how much you’re really paying for their services.
What’s been your experience with broker fees? Have you found yourself surprised by hidden costs from a “free” brokerage? We’d love to hear your stories in the comments!
FAQ: Common Questions About Broker Revenue
Are zero-commission trades really free?
No. Brokers offset these by making money through payment for order flow, interest on cash balances, and upselling premium services.
How much do full-service brokers typically charge?
Most charge between 1% and 3% of assets under management annually through wrap fees, plus potential additional fees for specialized services.
Do all brokers have a fiduciary duty to clients?
No. Only certain types of advisors (like RIAs) are required to follow the fiduciary standard. Many brokers only follow the lower suitability standard.
What’s the difference between how robo-advisors and traditional brokers make money?
Robo-advisors typically charge much lower management fees (0.25%-0.50% vs 1%-3%) and have fewer additional revenue streams than full-service brokers.
How can I minimize what I pay to brokers?
Understand all fee structures, keep cash balances low, avoid unnecessary trading, be cautious with margin, and choose services that align with your actual needs rather than paying for features you won’t use.
What is the difference between a trading broker and a stockbroker?
Trading brokers and stockbrokers might sound like they perform the same function, but there are some distinct differences. While stockbrokers focus on buying and selling shares, trading brokers might give you access to other markets like forex and indices.
The biggest difference between them is how they make their money. Stockbrokers usually make most of their money from the commission they charge. Trading brokers, on the other hand, tend to make their money from the spread, as well as commissions, overnight funding and other fees.
We act as both a stockbroker and a trading broker, giving you the best of both worlds. If you choose to trade with a broker like us, you’ll get access to over 18,000 markets including shares and several exclusive 24/7 opportunities.1
How do stockbrokers make money?
There are many ways that stockbrokers make money from their clients:
Typically, stockbrokers earn a living from the commissions charged to open or close positions for clients. This could be as a flat-rate, on a per-share basis or as percentage of your total trade value when you open and close a trade.
By choosing us as your stockbroker, you’ll get access to our low dealing costs and over 13,000 shares, funds and investment trusts to choose from. To open a trade you’ll pay lower commission of 2 cents per US shares (and 0.18% on Hong Kong shares) with a minimum of $15.
To ensure that their clients stay engaged, stockbrokers often charge custody or inactivity fees. Simply put, this is a small amount you’ll be charged monthly if your account has seen no trading activity for an extended period.