Payment for Order Flow, Net Interest Compensate Brokers That Don't Charge Commissions

Over the past few weeks, a number of major online stock brokers, including TD Ameritrade and Charles Schwab, have announced that they will be adopting a zero-commission model.

Robin Hood popularized the zero-commission model, and this has helped propel the company to a multi-billion dollar valuation. Robin Hood is extremely popular with millennial investors, and the big online brokers obviously don't want to lose this market.

A few weeks ago, Interactive Brokers announced a "Light" version of their trading software that would have zero commissions. The week after, TD Ameritrade and Charles Schwab followed suit, which resulted in a cratering of online broker share prices.

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A common question that is asked - how do brokers make money with a zero-commission model?

Robin Hood raised eyebrows last year when they revealed that they were making hundreds of millions of dollars from selling their customer's order flow. Anybody who knows the industry, however, was not surprised by this revelation, as Robin Hood had to be making money somehow. Net interest is nice, though it won't keep the lights on at a place like Robin Hood.

Selling order flow occurs when a broker directs your order to a market maker or high frequency trading firm. These firms will provide cash to the brokers (on a $ per share model) for directing order flow their way.

For a big online broker, selling order flow would net hundreds of millions of dollars per year.

Market makers and high frequency traders will be able to jump in front of these orders and make a tiny amount per trade, though over the course of a year, they'll (presumably) make a small fortune.

The downside to the person executing the trade? They probably won't get as good of a fill as they would if the broker weren't selling their order flow, and instead tried to find the best possible price for their customer.

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Another important way that brokers make money in a zero-commission model? Net interest.

With billions upon billions of dollars in customer assets, these brokers can sweep all this money into money market accounts and pay their customers either nothing (if you don't have enough in your account to quality) or less interest than what they receive. This is net interest, and is similar to how banks work.

On top of that, brokers earn margin interest and other fees (account closing fees, transfer fees, etc).

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The stock market, however, spoke loud and clear this past week - switching to a zero-commission model is not a good thing for these big brokers.

Filed under: General Knowledge