How Robinhood and Other Low- (or No-) Cost Brokers Make Money
To make money on Wall Street, you must have an information edge. The most successful investors on the planet tend to know something others don’t.
But with our culture’s disgusting lack of investment education, most folks looking to make a trade don’t have the most basic of information... let alone a profitable scoop that no others have.
We were reminded of this last week when we wrote about plunging online brokerage fees.
After we revealed a few low-cost trading platforms, our inbox lit up with notes from readers curious how companies like Robinhood, which charge no fees to trade a stock, can stay in business.
How, if brokers are in an all-out price war, will they remain profitable?
The questions illustrated a grand idea... that very few folks know just how their brokers are making money.
Let me count the ways...
First, all that cash in your account? It’s not really there. Of course not.
Like any bank, your broker lends that money to somebody else. Or it sticks it into an account where it draws its own interest on it.
You may be getting 0.15% each year for the $10K worth of cash in your account... but the broker may be getting 0.50% or more.
Perhaps you’re wise to the idea and don’t hold much cash in your brokerage account. You’re in the minority... big time. Our sources show roughly $600 billion worth of cash is on virtual loan to the brokerage industry at any time.
It leads to a revenue stream worth billions of dollars in interest each year for brokerage firms - just from the cash you’re doing nothing with.
If you don’t want to be part of this moneymaking operation, keep all unnecessary cash out of your brokerage account and in a high-rate savings account. Or, just as good, ask your broker to put you in a high-interest sweep account. Chances are it offers one... but it certainly doesn’t advertise it.
The Tricks of the Trade
The real money, though, isn’t made with your cash. It’s made when you start using that cash.
Brokerage firms have all sorts of ways to make a little money from a lot of folks.
First, let’s say you place an order to buy shares of a company at $10 per share. Perhaps your broker already owns the shares because it bought them from the last guy at $9.50.
It will gladly sell them to you for $10 each... and collect a $0.50 profit.
Or what if you enter your trade at $10 and the broker doesn’t have the shares in its inventory? That’s OK... its traders are well-connected. They know people. In fact, they make the market.
With a few keystrokes, the bid is out, and the broker has the shares for $9.95.
Ah, but your order says you’re willing to pay $10... So the broker grabs a quick nickel.
Perhaps you’re not sitting on a big pile of cash, and you aren’t making trade after trade in your account. You’re one of the millions of Americans who think they’re not feeding the Wall Street machine.
Your Money... Their Money
It’s not much different than the countless credit card holders who wrongly think they aren’t adding to their bank’s profits if they pay off their balance each month. They are. Every time we use our cards, the merchant hands roughly 3% of our total bill to the credit card company.
It’s a similar story in all of those low-cost, no-trading-fee ETFs.
When you buy shares of an ETF or index fund, you are not only agreeing to its annual fee (which averages 0.44% for ETFs and 0.74% for index funds), but you’re also buying slices of the underlying stocks in that fund.
If your broker happens to be the sponsor of that ETF... you’re putting shares of hundreds of companies into its coffers that it can loan out, sell to others, etc. (Why do you think it incentivizes you to buy its ETFs or mutual funds over the next guy’s?)
Things get really crazy when dealing with synthetic or swap-based ETFs. Wall Street knows how to have a whole lot of fun with just some paper and some promises.
As long as the broker follows certain margin rules and abides by key ratios, it can do magical things with your investment dollars - the assets that most folks wrongly believe are just sitting in their accounts gathering dust.
The list of ways a brokerage house makes money continues... and gets only more complex.
We haven’t touched the subject of brokers lending your shares to short traders.
Or the money they make on margins.
Or, get this, how many brokerages eagerly bet against their customers.
The truth is... just like the dollars in your savings account, the investments you have sitting in your brokerage account are doing anything but gathering dust.
They’re making somebody - certainly not just you - a slew of money.
So again, how does a company like Robinhood, that charges no commissions, make its money?
Let me count the ways.
If you think your cheap online brokerage isn’t making money off of you, think again.
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