How Zero Works

For the past seven years, buying and selling US shares has been commission free. Although initially the phenomenon started with a few disruptors looking to shake things up, over the last 12 months all major US brokerage houses have dropped their fees to the floor.

In this article, we take a look at all the different ways various brokerages make money in order to offer commission-free. A number of these practices are not something we engage in at Stake.

For those who aren’t deep in the trading or brokerage space, zero-commissions makes little sense, wondering how these brokerage firms make money. For those on the inside, it’s totally logical. So much so is trading with commission-free platforms the norm, that paying for trades would now be considered ludicrous.

If you have a quick glance of this market structure in the US, it paints a pretty simple picture — the money in brokerage is not made in brokerage. For years, execution-only platforms in the US have been making significant revenue on the “back-side” of a trade, which is the purpose of this article.

The 4 major ways brokerages make money without charging brokerage

  • Rebates & Payment for Order Flow
  • Interest on Cash
  • Margin, Data & Other Products
  • Securities Lending

Rebates & Payment for Order Flow

Who would have thought Kansas City had a stock exchange….aka BATS. What about the PICO (Pacific Exchange out of San Fran). These are just 2 of the 13 stock exchanges in the US.

In the US, equity trades can happen on any of these multiple exchanges. This means these venues are competing for investors’ order flow, which ultimately drives more revenue to exchanges via trade fees, data, collateral and so on. To get this order flow, exchanges actually pay market makers and execution firms to trade on them.

These rebates then get passed on to the broker who “sells” their flow to those market makers (Citadel, DRW, GetCo etc) who ultimately execute on the exchange for a rebate or trade against the flow for profit. This practise of brokers selling their order flow (aka Payment for Order Flow) is well known and some would argue, well accepted in the US (not so much in Europe….).

With Regulation NMS (think “best execution”) in force, brokers are obligated to make sure their customers get the best price for their orders (a good thing), but it means for a broker, it’s just easier to pass through your trade to a market maker to meet that obligation and get paid for it. It’s lucrative too, with market makers and big brokers making hundreds of million each year on the practice.

This structure and process is totally unique to the US and not really replicated anywhere else in the world. It means that the phenomenon of zero-commission brokers will (for the near term) predominantly be isolated to trading in US equities only.

For the record, Payment for Order Flow is not something that Stake practices.

Interest on Cash

Quite simply, brokers around the world make money on idle cash sitting on accounts. This is common in all markets. The old, established brokers have generated huge FUM (funds under management) and a huge proportion of their revenues are generated on the gap between what they pay customers and what they keep for themselves.

Even in 2020 with rates nearing record lows globally, it’s estimated that nearly half of Schwab’s revenue came from net interest margin, which means it’s in the multiple billions of dollars. That’s one hell of a business when rates move back up!

You see exactly the same all around the world. Scale matters. It gives you a massive head start and cash to rely on. This means the move to zero changes the landscape for both the customer and any future players in the space.

Margin, Data & Other Products

Digital brokers are much more than just execution. Selling services ancillary to execution is a classic of established players.

Commission-free trading needs everything that ‘paid for’ trading needs. Data, research, service and support. Often, each of these is charged onto the customer. Quality data in the US can be expensive and is charged back to the customer with a premium attached.

Similarly, margin is a popular driver of revenue for brokers who offer it. They lend cash out to investors to invest at a higher price than what they pay. With cash rates really low, the opportunity to borrow cheaply and on-sell to customers is a solid additional line item for the broker.

Securities Lending

Big brokers have lots of stock on their books. Billions and billions of assets. With this scale, they are able to lend it out to trading firms and investors that want to bet against the stock. Before that investor or firm can sell a stock short, they need to borrow it from someone holding it. This is known as securities lending.

These brokers set up a process for those who want to borrow certain securities to do so, at variable rates. The rates are determined by the supply and demand for that security. Brokers get paid for their assets and are then able to pass it on with savings on the front end with reduced trading costs. The more assets, the more made on securities lending.

It All Adds Up

If you take a dive into into the financials of the listed US brokers, such as Charles Schwab, E*Trade (before it got bought by Morgan Stanley), you’ll quickly see how this adds up. For example, prior to setting its brokerage to $0, it was estimated that Schwab made only 7% of its revenue on trading.

As the CEO of Stake, a digital-first commission free brokerage for US shares, we’ve seen that first hand. With 77% of our customers having traded before, only a quarter had bought or sold US shares before trading on our platform. What this shows is that the barrier to trading in the world’s biggest and most dynamic market is access not appetite; and that’s why we exist. So for the mavericks out there, things keep getting better, as they always do — more opportunities, with less friction and less cost.

So, as we like to say, Happy Trading.
Matt.