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How do commission-free brokers make money?

how does robinhood make money

Being about to buy stocks at 0% commission is now the norm across many online brokers. Not only does this include new-age platforms like Robinhood and Webull – but also established brokerage firms such as Fidelity and Charles Schwab.

So that begs the question – how do commission-free brokers make money if they do not charge fees on stock trades? After all, brokers are in the business of turning a profit.

In this market insight, I explore the truth about 0% commission brokers – in terms of how you are actually paying fees to buy and sell stocks.

How do commission-free brokers make money? Quick overview

If you’re simply looking for an overview of how commission-free brokers make money, below I explain the key points to take note of.

  • In many cases, commission-free brokers make money through the spread. This is the gap between the ‘bid’ and ‘ask’ price of the stock you are trading.
  • You can be sure that commission-free brokers offer a less competitive spread in comparison to those that charge traditional trading fees.
  • As such, this could be viewed as a hidden cost, as inexperienced traders are often unaware of what the spread is – let alone how much is being charged.
  • Another area that commission-free brokers make money from is by selling your orders to third-party market makers. In turn, the market maker might execute your stock trade at a less favorable price.
  • Money can also be made by charging deposit/withdrawal fees or interest on margin financing.

I discuss the above key points in great detail throughout this market insight.

How commission-free brokers turn a profit – The basics

Before the age of digitization, traditional brokers would make the vast bulk of their income by charging commissions. This would usually come in the form of a flat fee on each buy and sell order. For instance – irrespective of the amount being traded, you might pay $10 per transaction. Some brokers would instead charge a variable commission – such as a 0.5% fee on each position.

However, fast forward to the current era of online trading, and pricing structures have since been turned upside down. That is to say, there are now dozens of online brokers that allow you to buy and sell stocks on a 0% commission basis.

how does robinhood make money

Brokers are, of course, in the business of making money. As such, it is important to understand how brokers are able to turn a profit on trades that attract no commission.

As per my in-depth research into this subject, I can conclude that commission-free platforms are able to make money from you in various ways. This centers on the spread and payment for order flow practices.

What is the spread? 

If you’re unfamiliar with the spread, it is crucial that you know how this trading term works – as this is an indirect fee that you are paying to the broker.

In its most basic form, the spread is the difference between the bid and ask price of a stock. In other words, this is a mark-up between the actual price of an equity.

  • The bid price is the highest price a new buyer will pay for a stock
  • The ask price is the lowest price a current holder of a stock is willing to accept to offload their shares

To reiterate, the difference between the above two prices is referred to as the spread – and the easiest way to calculate this is in percentage terms.

For example:

  • Let’s say that you are looking to trade Tesla stocks
  • As per the NASDAQ exchange, Tesla is trading at $1,086.00 per share
  • However, at your chosen commission-free broker – you see two different prices on Tesla stocks
  • Your broker offers a bid price of $1091.43 and an ask price of $1080.57
  • The difference between these two prices is 1%

As per the above example, you are indirectly paying a fee of 1% to buy and sell Tesla stocks. Therefore, although you are not paying a commission per-say, you are still being charged a fee to trade.

What spreads do commission-free brokers charge?

The most frustrating thing about almost all commission-free brokers is that the spread is never advertised when you go to place a trade. In my view, this means that the spread at zero-commission platforms is a hidden fee.

As such, you will likely need to calculate the spread yourself to assess whether or not you are getting a good deal. As you can imagine, this can be a laborious task, especially when you consider that both stock prices and the spread itself will fluctuate throughout the day.

how does webull make money

Most commission-free brokers that target retail clients will operate a variable model. This means that the spread is likely to be a lot more competitive during busy trading hours.

Payment for Order Flow

Commission-free brokers like Robinhood and Webull both operate a revenue stream known as payment for order flow.

This practice works as follows:

  • You buy $1,000 worth of Apple shares via Robinhood
  • Robinhood does not execute the order itself. On the contrary, the broker will sell your Apple stock order to a third-party
  • This third-party – known as a market maker, will pay Robinhood a fee for your order
  • The market maker will execute the trade by purchasing Apple shares at a lower price than you paid via your Robinhood account
  • The difference between the two prices – also referred to as the spread, allows the market maker to generate a profit from the trade
  • In turn, this allows Robinhood to make a profit without even needing to execute any trades itself – as it collects a fee from the market maker

The payment for order flow process is somewhat controversial, as there is a conflict of interest at play. That is to say, there is every chance that the commission-free broker will look to send your orders to market makers that are offering the best deal for them at the time of the trade.

This means that from your perspective, you might not be getting the most competitive price possible when buying and selling stocks.

How much do 0% commission brokers make from payment for order flow?

Make no mistake about it – commission-free brokers make significant profits when engaging in payment for order flow practices. The key problem is that attempting to find clear data in terms of the figures is challenging. On the one hand, the SEC requires all brokers operating in the US to publish their payment for order flow statistics.

However, being able to access these statistics is another story. The most recent data that I could find covers payment for order flow statistics for four online brokers across Q1 and Q2 2020. This includes TD Ameritrade, E*TRADE, Charles Schwab, and Robinhood.

payment for order flow stats

As you can see from the above image, profits on payment for order flow can be significant. Across these four brokers in Q2 2020 alone, more than $180 million was paid by third-party market makers.

Once again, this is simply for obtaining retail client stock orders, which the market maker will then profit from by executing your position at a less favorable price. And therefore, although you are not paying a commission to buy and sell stocks per-say, you are losing out via the spread.

For example, if you are paying a spread of 0.5% on the position, this means that you are buying the stocks at 0.5% more than the actual market price. And as such, you would need the value of your stock trade to increase by 0.5% just to break even. In other words, as soon as your stock order is executed, you are immediately 0.5% in the red.

Other revenue streams

In addition to spreads and payment for order flow, commission-free brokers can make money in other areas.

This includes the following:

  • Payment Fees: Some brokers will charge you a fee when depositing and/or withdrawing funds. For instance, if you withdraw funds from Webull via a bank wire, you will be charged $25.
  • Overnight Financing: If you decide to trade stocks on margin, you are essentially borrowing the funds from the broker. As such, you will need to pay interest on a margin trade for as long as the position remains open.
  • Account Fees: Some platforms will offer premium accounts that attract a monthly fee. For example, Robinhood charges $5 per month for its gold account – which offers higher deposit limits and access to margin trading.

How do 0% commission brokers make money? Conclusion

In summary, 0% commission brokers will typically generate the vast bulk of their revenue streams from two key sources. The first is via the spread – which is the mark-up between the bid and ask price of a stock. The second – and perhaps most controversial, is through payment for order flow.

This is where third-party market makers pay 0% commission brokers for their order books. In turn, not only does this result in you getting a less favorable price on your stock trade, but there is also a conflict of interest at hand. Ultimately, this is why you need to have a firm grasp of what fees you are actually paying when buying and selling stocks online.

FAQs

How do zero commission brokers make money?

Zero commission brokers can make money from various sources. This includes payment for order flow, the spread, deposit/withdrawal fees, and overnight financing.

What is payment for order flow?

Payment for order flow refers to the practice of brokers selling your stock orders to third-party market makers. In turn, the market maker will pay the broker a fee for all orders that are passed its way. The market marker will then execute the trade on behalf of the broker.

Is better to pay a commission when trading stocks?

This depends on the spread that the broker charges. For example, even though your chosen broker might charge a commission, it might offer a spread that is very competitive - which is the gap between the bid and ask price of the stock. On the other hand, 0% commission brokers might charge a less favorable spread.

How does Robinhood make money?

Robinhood makes a large chunk of its money by selling stock orders to market makers. It also makes money on its gold account at $5 per month, as well as on margin trading financing.

What is the best commission-free broker?

To choose the best commission-free broker, you should spend some time assessing whether or not the platform engages in payment for order flow. You should also assess the spreads charged by the broker, what markets are supported, and whether or not your preferred payment method is accepted.

 

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Kane Pepi

Author: Kane Pepi

Kane Pepi is a researcher and writer involved in the financial and cryptocurrency scenes. Academically, Kane holds a Bachelor's Degree in finance, Master's Degree in financial crime, and is currently engaged with a Doctorate researching the money laundering threats of the virtual economy.  Keen interests include travelling, playing tennis, and watching rugby.  

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