How Do Commission-free Brokers Make Money?
Robinhood, as a pioneer of commission-free investing, started the revolution of charging zero commissions for stock, ETF trading. As more and more brokerages, like Charles Schwab and Fidelity, followed suit, you must be wondering how commission-free brokers make money.
There are four major ways for commission-free brokers to make money-
Interest on cash balances
Commission-free brokers generate income on uninvested cash by depositing this cash in interest-bearing bank accounts.
Payment for Order Flow
When you buy or sell stocks, ETFs, and options through your brokerage account, your orders are sent to market makers for execution. Brokers usually have relationships with a number of market makers such as dealers and securities exchanges. To compete with exchanges, market makers offer rebates to brokerages.
Brokerages receive a rebate on certain transactions when they direct your orders to order routing destinations. In general, market makers are willing to pay brokers for order flow because they believe retail investors, being driven by emotion or the need to raise cash, will provide mispricing opportunities for them to profit from.
Bear in mind, in the United States, accepting payment for order flow is legal as long as no other trading venue is quoting a better price and the broker have informed its client in writing –
- Upon the opening of the brokerage account
- On an ongoing annual basis
- On trade confirmations
If you really want to know why market makers is incentivized to pay for order flow, you ask the right question and a glimpse into HFT (High Frequency Trading) by reading Flash Boys will help you.
Commission-free brokers earn income from lending stocks to counterparties.
In the market, there are people whose investment strategy includes shorting stock. Short selling means that someone will borrow stock in order to sell it at the current market price, and with the end goal of buying it back at a lower price and returning the borrowed shares to the lender.
It is much like lending money to someone and charging interest. In this case, your brokers lend securities to short sellers and charge short interest.
Value-added Services refer to services such as level-2 market data, margin trading, T+0 settlement, instant deposit/transfer. Most of the time, you can enjoy such services a la carte and brokers such as Robinhood adopt a freemium business model and package services into a membership subscription program called Robinhood Gold.
Now you should be able to understand how commission-free brokers make money by having you invest with them. Below is a list of recommended brokers for you to investigate –
Traditional Commission-free Brokers
- Vanguard Brokerage
- Charles Schwab
- TD Ameritrade (Acquired by Charles Schwab)
- E*Trade (Acquired by Morgan Stanley)