EXCLUSIVE: With Today’s Volatility, How Do Online Brokers Make Money?
The market has continued to slow down in 2022 as payment models are beginning to fail and people are fearing another period of financial instability. However, volatility means opportunity and for online brokers, the uncertainty of the market climate could very well be ‘the perfect storm’ when it comes to commission-free trading.
Commission-free trading has taken off in the last few years, with the number of new registered users on commission-free platforms accelerating at a faster rate than more traditional investment platforms. Robinhood, Freetrade, Revolut have all benefited from the model. Plum very recently announced its plans to launch commission-free stock investing in the UK, giving users more freedom to balance their portfolio and to rebuild some confidence that has been lost from consumers.
At this crucial inflexion point, it begs the question – is commission-free trading sustainable, profitable, and quite simply strong enough for our current situation? Despite PwC’s Consumer Sentiment Survey of Spring 2022 showing a drop-off in consumer sentiment and confidence, fee-free trading, for the first time, has empowered users about how to invest.
Let’s understand the technical aspects here of how online brokers actually make their money.
Payment for Order Flow: PFOF is a primary way that brokerages make money from commission-free trades. PFOF occurs when a broker that sources liquidity and executes orders for its clients receives a fee from both the client that originates the order and the counterparty the trade is then executed with. However, PFOF is clearly problematic and is unlikely to meet regulatory requirements under the MiFID II framework. In 2019, the FCA noted that “PFOF makes it more likely that extra costs will be passed on to the broker’s client, through wider bid-ask spreads from market makers and other liquidity providers who agree to pay PFOF to attract order flow from brokers. While the impact of PFOF may not be visible in bid-ask spreads for each transaction, it is likely to affect aggregate spreads as liquidity providers need to account for the payments made to brokers. These hidden costs make the price formation process less transparent and efficient.” No wonder it’s banned in the EU and under review in the US…
Margin Lending: ML is a type of loan that allows you to borrow money to invest, by using your existing shares/funds/cash as security. The amount you can borrow is based on your financial position as well as the allowable Loan to Value Ratio (LVR) of your existing portfolio, being your shares/funds/cash used as security. If the value of your security drops in relation to the loan amount, you may exceed the maximum LVR. This will trigger a ‘margin call’ and you’ll be required to either reduce your loan amount, contribute additional security or sell part of your investment until your LVR is below the maximum. This is the clear risk with ML, despite it being beneficial for allowing you access to more funds.
Cryptocurrency Trading: Cryptocurrencies have become a respected constituent within the mainstream market. Crypto trading involves buying and selling cryptocurrencies via an exchange by speculating on price movements against the dollar or against other cryptos. This craze will continue. “We’ve seen that interest and trading activity in cryptos grew at a higher pace among customers compared to the growth in equities,” said Adam Nasli, lead analyst at BrokerChooser. Regulatory insight is inevitable and with many fearing missing out, the proliferation of NFTs and just the sheer establishment of crypto as a valid asset class, more people will enter this space.
Securities Lending: SL could very well lead the industry in terms of how users approach trading in the future, despite existing for 60 years already. Different from PFOF and ML, SL is the practice of loaning shares of your stock to other investors. You’re essentially renting them out, a very innovative way of looking at the situation as it can allow you to generate additional interest if you are a long term holder of a security. The renter transfers other securities, such as cash, to the lender, by way of collateral. The more widely available stocks, known as ‘general collateral’, generally produce lower returns, of up to 0.5%, whilst hot stocks, known as ‘specials’, can command much higher rates.
SL is occurring largely in the ETF space, as more people recognise the benefit of passive income, hence passive investing. And given the age we are living in, where assets are harder to acquire because of increasing inflationary pressures and the sharp rise in the cost of living, a key question emerges; can you really afford to leave money on the table? Recent data revealed the global securities finance industry delivered US$828 million in lending revenue in April 2022, a 20 per cent increase on April 2021, according to data from DataLend. The top five revenue-generating securities for April 2022 were Rivian Automotive, iShares iBoxx $ High Yield Corporate Bond ETF, Sweetgreen, Beyond Meat and GameStop. These five securities generated more than US$53 million in lending revenue during the month. The money is there for the taking.
E-brokers have documented record trading revenues despite dropping commissions to zero, but what might change in how they operate for the future?
Revenue maximisation and growth is no doubt fun when it comes to commission-free trading, but the race for profitability will become the priority. CEO of Robinhood, Vlad Tenev, announced that after a period of rapid growth throughout 2020 and H1 2021, where the company’s net funded accounts grew from 5M to 22M, headcount soared from 700 to nearly 3800 in the same period. This led to some duplicate roles and job functions, highlighting areas of inefficiency and exposing where automation may be more beneficial to optimise operational efficiency.
This will no doubt be echoed throughout the industry as time goes on and automation, AI and machine learning continue to advance and optimise the scope of capabilities for online brokers.
As aforementioned, Securities Lending has been highlighted as a potential saviour for the industry and you can guarantee that the discussion of its effectiveness will permeate amongst the industry through the year, as it represents the next dominant phase of online brokerage.
Lots of questions are to be asked here though. Beyond the financials, is short selling ‘bad’? Are you willing to rent your stocks and use the profit to dollar-cost average your additional investments? Or do you view that potential profit of investment as yours, and yours only? Let’s wait and see as our industry leaders dial in on the topic.