Saturday, November 23, 2024
In 2020, the most recent year for which I could find numbers, TD Ameritrade, the prominent, well-regarded discount brokerage operation earned an operating profit of an astounding $1.93 billion, on sales of over $4.3 billion. These results are impressive on an absolute basis. $1.9 billion is a lot of money. But they are more impressive as a percentage of sales. A profit margin of over 44%, in a hyper-competitive industry.
For the sake of contrast, for the same period, General Motors had sales of $122.5 billion and profits of $6.3 billion. One of the largest, best-managed, and best-recognized brands on earth had a profit of 5%. I suspect that the vast majority of large companies have profit margins much closer to General Motors than TD Ameritrade. TD Ameritrade must be a well-managed business indeed.
Yet, if you visit the company’s website you will see the following, prominently displayed on the home page: “Commission-free, online trading and no hidden fees.”
Commision free! Huh?
So, a brokerage business charges no commission and rakes in fabulous profits while an auto manufacturer that sells some cars for more than $100,000 each, makes average returns? What gives?
On May 1, 1975, “May Day” the investment business was shaken to its foundations. Before that date, brokerage commissions were fixed. Everyone was charged the same price regardless of the size of the trade and, as a result, small investors were wildly overcharged. As of May Day, the Securities and Exchange Commission deregulated trading commissions. One consequence of this was the revolutionary rise of discount brokerage companies.
In no small irony, one of the very first of these was Charles Schwab which, while founded in 1971, began offering discounted commissions shortly after they were deregulated. In 2020, Charles Schwab acquired TD Ameritrade, the broker we referred to in the introduction to this article!
The advent of technology and the rise of online trading platforms have furthered the revolution. In recent years, no-commission brokers have arisen, such as Robinhood, eToro, and others, have disrupted the market by eliminating commissions and attracting a large user base and trillions of dollars in assets.
As it turns out, no-commission brokers have many revenue streams. They include:
Let’s discuss each in detail.
Payment for Order Flow is a payment, essentially a rebate, that a broker receives in return for directing their trading business to a particular stock exchange or market maker. This payment is extremely small, typically a fraction of a penny per share but with trillions of shares trading hands each day, it can amount to a significant revenue source. According to the US Securities and Exchange Commission, “payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”
But you might ask, “A rebate of what? If I’m paying nothing to execute the trade what is the source of the rebate?”
Good question. Although absolutely legal, and justified by the need to maintain orderly and liquid markets, Payment for Order Flow has been controversial. In essence, the concern is that retail customers are not getting the best market price available. In other words, the concern is that your discount broker is “marking it up to mark it down.”
That practice is explicitly illegal but probably exists, to a certain extent, implicitly. Let’s face it. If you’re buying or selling 100 shares of General Motors, you’re probably not getting the same price as the State of California’s pension fund, which is trading a million—or ten million—shares.
Brokers are required to disclose to their customers the amount of revenue they earn from Payments for Order Flow and the quality of their trade executions generally, although this data has been called into question, and the industry has been working on improving it.
Regardless, these amounts are extremely small and have next to no impact on outcomes for a buy-and-hold investor.
Interest on Cash Balances is another source of revenue for no-commission brokers. When investors deposit funds into their brokerage accounts or receive the proceeds from the sale of securities or stock dividends, a portion of those funds often remain uninvested. No-commission brokers pool these cash balances and invest them in low-risk, interest-bearing instruments, such as money market funds. The interest earned on these cash holdings contributes to the broker's revenue.
By investing the uninvested cash balances of their clients, no-commission brokers can earn interest on what amounts to a substantial amount of capital. While the interest rates on these investments might be low, the sheer scale of cash balances across a large customer base can generate a significant revenue stream for the broker.
Margin Trading. No-commission brokers often offer margin trading as an additional service to their clients. Margin trading allows investors to borrow funds from the broker to trade securities. Brokers charge interest on the borrowed amount, generating revenue from the interest payments made by margin traders. While margin trading carries additional risks, it is an attractive option for some investors who seek to amplify their potential returns.
Margin trading provides an opportunity for no-commission brokers to earn interest income on the funds lent to clients. Brokers carefully assess the creditworthiness of margin traders and set appropriate interest rates based on market conditions and the level of risk associated with the trades. By offering margin trading services, no-commission brokers can cater to investors who are willing to take on additional leverage and generate revenue from these traders.
Securities Lending is another way no-commission brokers can generate some income. When investors hold stocks in their brokerage accounts, brokers can lend those shares to other market participants, such as short sellers, who aim to profit from price declines. In exchange for borrowing these shares, borrowers pay a fee to the broker. No-commission brokers typically pass a portion of this fee onto the investors who lend their securities while retaining a percentage as revenue.
Securities lending provides a mutually beneficial arrangement for both the broker and the investor. Investors can earn additional income by lending out their securities, while the broker facilitates the lending process and earns a fee for the service. This revenue stream is particularly relevant for no-commission brokers who typically have a large user base and a substantial pool of securities available for lending. Most brokers offer customers the option to withhold their securities from the securities lending marketplace, although there is no risk that your shares won’t be returned. The reason an investor might make such a choice is complicated and beyond the scope of this discussion. Securities lending is a thing and one of the ways your broker generates revenue.
Premium Features and Upgrades. To further supplement their revenue, some no-commission brokers offer premium features or upgrades for a fee. These features might include advanced trading tools, access to market research, real-time data, or premium customer support. By providing additional value-added services, brokers generate revenue from clients who are willing to pay for enhanced trading capabilities or support.
These premium features and upgrades allow no-commission brokers to cater to different segments of investors who require more sophisticated tools or personalized assistance. By offering tiered membership or subscription models, brokers can provide a range of options to clients while generating additional revenue from those who opt for premium services.
While we’ve discussed the revenue sources most all no-commission brokers use, there are a handful of others that contribute, perhaps to a lesser extent to their top and bottom lines.
Account Maintenance Fees Some no-commission brokers may charge their customers account maintenance fees or subscription fees for access to certain features or services. These fees could be based on a tiered structure, where clients who opt for advanced features or higher account levels pay a recurring fee.
Data and Analytics Services No-commission brokers can offer data and analytics services to investors for a fee. These services provide in-depth market research, real-time data, customized insights, or access to proprietary tools and indicators, allowing traders to make more informed investment decisions.
Asset Management and Robo-Advisory Services Some no-commission brokers expand their offerings to include asset management services or robo-advisory platforms. These services typically involve creating and managing diversified portfolios for investors based on their risk profiles and investment goals. Brokers charge management fees based on a percentage of the assets under management.
Partnerships and Referral Programs No-commission brokers may establish partnerships with other financial institutions, service providers, or product vendors. Through referral programs or revenue-sharing agreements, brokers can generate income by directing their clients to these partners' services or products.
Advertising and Marketing No-commission brokers can leverage their large user base and platforms to generate revenue through advertising and marketing partnerships. They can display targeted advertisements or promote third-party products and services to their customers, earning revenue from advertisers or through affiliate marketing programs.
As we have seen, so-called no-commission brokers have lots of ways to make money. Perhaps it’s no wonder why they are so profitable. Here at Financial Animal, we believe the best strategy to accumulate wealth that will last an active, safe, and secure lifetime is to buy and hold a portfolio of mutual funds, trading only four times per year to rebalance that portfolio. If an investor follows this strategy, these charges that add to the revenue of your broker will have no impact on the achievement of that goal.
