How your broker gets paid (II)–how the brokerage firm benefits

How your brokerage firm makes money

In my earlier post on broker pay, I wrote about how the individual broker is compensated.  This post deals with the broker’s firm, which also gets paid for its customers’ activity in several ways.  Please note that I’m writing about practices in the US.   My experience has been that it’s the same in other countries are similar, however, other than that foreign charges (ex IPOs) are generally much higher.

Let me count the ways:

1.  commissions/fees The broker’s firm keeps a percentage, 50%+ in the case of traditional brokerage firms, of the gross commission/fee income that an individual broker generates.  It pays the remainder to the broker.

2.  margin interest The brokerage firm may arrange for or provide loans itself to clients to buy stocks on margin.  Its cost of funds is now something around 1%.  But it will charge clients, say, 4%-7% interest on the loans, netting the difference as profit.

3.  stock lending In all likelihood, when you opened your brokerage account you signed an agreement giving your permission for the brokerage firm to lend the shares in your account to third parties, from whom it collects fees.

4.  trading fees Yes, you may pay a commission on many trades.  But your broker is doubtless a market maker for some of these securities and earns a bid-asked spread whenever he matches a buyer with a seller.  In the case of options or other derivatives, this spread can be 10% of the principal value of the transaction.  For an “active” trader, who moves in and out of securities frequently, these spreads can really mount up.

Your firm may also direct order flow for securities it doesn’t handle internally to third parties in return for a fee (there are rules to protect you from abuse, and fees are lower now than they once were, but this is still a source of income).

5.  distribution fees In addition to their trading activities, brokerage firms around the world are the predominant vehicle for distributing securities of all types.  In the institutional market, this means handling public offerings of stocks and bonds.  In the US, the typical fee a company pays to a broker for underwriting and selling a stock offering is 7% of the amount raised (much higher than in the rest of the developed world).  A broker can’t get an assignment like this without strong customer relationships.

The equivalent in the world of individual investors (I’m assuming that individuals normally only get the dregs of the IPO market) is distribution fees for mutual funds.   Just as in the institutional world, a strong distribution network, whether online or through registered reps in bricks-and-mortar offices, is a very valuable asset and isn’t given away for free.  So, just like a supermarket collects a stocking fee from companies wanting shelf space, a broker may collect a percentage of the mutual fund management fee in return for providing “shelf space” for that fund on its distribution platform.

Arguably, this is an issue between the broker and the fund company, since it’s about who gets the management fee you’re paying, not how much you pay.  It can be a matter of concern, though, if it turns out that when your broker runs an asset allocation analysis for you in his office, the only mutual fund recommendations that pop up are the ones who share the management fee.   They may still be the best funds, but in this case I think you have a right to know the brokerage firm’s interest.

Conclusion

For an investor, who will typically make a small number of focussed transactions each year, the commissions and fees he pays are the largest share of the compensation a brokerage house receives.  We’re not their favorite customers.  On the other hand, for “active” traders, who transact often, use margin and trade in derivatives, the commissions and fees are only the tip of the iceberg.  No wonder the TV commercials for discount brokers all focus on how cool and sophisticated rapid-fire trading is (there are more reasons for this tack than just it makes the most profit for the broker to encourage trading…but that’s a topic for another post).

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