How Brokerages Make Money

As a kid, I always wondered about how banks made money. They help keep my money safe and pay me a small interest on top of that. What a great deal, I thought.

It was only much later that I discovered that banks actually take my money and lend it out to other people at a higher interest rate and pocket the difference.

So for every $10,000 I put in the bank, if they lend it out at an annual rate of 5%, they will earn $500 from interest payment. The bank then pays me $50 for that $10,000 based on an interest rate of 0.50%. Their profit is $450.

Pretty neat right?

When I heard news of brokerages slashing their commission fees to zero in the US, it got me wondering again – how do brokerages make money?

#1 Fees

Stock Brokers earn a commission when they execute trades orders from investors.

To execute a trade, the broker will have to match the bid price of a buyer and to the asking price of a seller.

So each time we buy or sell a stock, the brokers earn a commission, usually a percentage of the price traded.

The more we trade, the more they earn.

Besides trading commission fees, brokerages also charge for other fees such as clearing fees, custodial fees, platform fees, inactivity fees etc etc…

So that was how they make bulk of their money.

That was usually the case, until Robinhood, an investment app that offered zero commission trades came into the industry.

#2 Interest On Your Deposits

Have you ever compared online brokerages and found out that the commission rates were much lower for a pre-funded account compared to a cash account?

A pre-funded account simply means that before you could place an order, you will need to have sufficient cash deposited in your brokerage account beforehand to fund the order.

On the other hand, in a cash account, you will only need to settle the trade after it is executed. You do not need to have the cash up front before placing the trade.

If you look at the commission rates for Phillip Securities as an example

	Commission Fees (Pre-funded)	Commission Fees (Cash Account)
Phillip Securities (POEMS)	0.12%	0.28%

Just an example, not a recommendation.

The reason for lower fees is that brokerages also generate revenue from deposits you had placed with them, like a bank does.

All the money that you had pre-funded in your brokerage account, the brokerage lends or invest your money generating higher interests and then pays you back a lower interest rate.

That is why they usually charge lower commissions to incentivize you funding the account and keeping your money with them.

#3 Margin Lending

Also, just like a bank, brokerages can also lend investors money known as margin lending.

Margin lending is where the brokerage will loan you money to finance for your investments using your existing shares as security for the loan.

They also earn interests from margin lending.

#4 Securities Lending

Have you also wondered why commission fees for custodian accounts are lower compared to CDP accounts?

A custodian account is an account where the broker owns the shares on your behalf.

A Central Depository account (CDP) is an account where you own the share directly.

Let us look at a comparison between FSMOne (Custodian) vs DBS Vickers (pre-funded):

Brokerage	Custodian or CDP	Commission Fees
FSMOne	Custodian	0.08%
DBS Vickers	CDP	0.12% for buy trades 0.28% for sell trades

FSMOne is by default pre-funded, hence DBS Vickers pre-funded account was used as a comparison

Many often advocate for CDP because you own the shares directly and will be able to attend AGMs, voting rights and chance of losing your assets if the brokerage goes bankrupt.

However, there is one more thing that brokerages do not talk about custodian accounts – they can lend the shares to make profit.

Under custodian accounts, the brokerage is the rightful owner of the shares and they are entitled to lend your securities (held in their custody) to other investors for short selling.

Short selling is basically the act of selling shares you do not own (which you have to borrow from somebody else) and buying back the shares later (in order to return the shares to the lending).

That is how they make up for cheaper commissions for custodian accounts – by profiting from securities lending.

#5 Payment for Order Flow

This is where Robinhood makes most of its money and also commonly used by many other online brokers (in US).

Whenever you submit an order to your broker, instead of placing the order in the open market, the broker may route your order to a market-maker to execute your order.

These market- makers are high frequency trading (HFT) firms that leverage technology to execute vast amounts of trades within fractions of a second.

The market maker will pay the broker a small fee for every order sent their way. This is referred as payment for order flow.

source: article from cnbc

However, HFT is opaque and often controversial because it gives large institutional investors an advantage over smaller organizations and retail investors – not a level playing field.

Nevertheless, that is the reason why Robinhood, TD Ameritrade, Schwab, E trade could reduce their commission fees to zero.

#6 Diversification Of Services

Another trend is the diversification of financial services offered by brokerages. They now offer asset management, financial planning, robo advisors, premium membership fees and other kinds of services.

One thing is for sure, they are all looking to diversify their streams of revenue.

Will Zero Commissions Come To Singapore?

As most brokerages in US move towards zero commissions model, one would also anticipate this move to gain traction around the world.

However, most of the methods of how brokerages earn money is quite different from brokerages here in Singapore.

Here is a look at the 2019 annual report for iFAST the company that owns FSMOne

Source: iFAST annual report 2019

Most of the non-recurring net revenue still comes from transaction fees and commissions (56.5%) hence it will be challenging for them to reduce it.

Compare it with US brokerage Charles Schwab:

Source: article

For Singapore, we still have a long way to go for zero commissions as we need more of the brokerages to depend less on commissions and fees for their main source of revenue.

The Singapore market is also much smaller volume compared to the US or HK markets, so it will be hard for Singapore brokerages to profit from payment of order flow.

Also, there is no competitive pressure as we do not yet have a Singapore equivalent of a Robinhood app. Hong Kong has a couple here and here.

Therefore, the best we could hope for is for TD Ameritrade or Interactive Brokers to offer zero commissions for US stocks here for Singapore accounts.

Or we could just rely on our trusted pre-funded custodian accounts brokers for lower fees to Singapore markets.

Conclusion

One thing is for sure, the business models of financial services are complicated and it is often hard, for an outsider like me, to know how they profit from average consumers like me.

The business of brokerages had evolved from a pure commission based model to a diversified model with several revenue streams.

Just remember that you are still paying something for the lower commissions (or zero commissions) as the broker will still find other ways to generate profit from you.

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