How do zero commission brokers make money?

There’s no free lunch in investing, right? So how do all those zero commission brokers make money?

How do they pay for their staff and equipment? How do they cover the cost of accessing the markets themselves? Not to mention complying with financial regulations?

Well there are many ways an enterprising broker can earn a living from your business.

What matters for us is:

• How are they doing it?
• Do you know about it?
• Are you paying a fair price?

It’s a bit like the magician who pulls money from your ear. The money’s coming from somewhere. Distraction techniques are a trick of the trade.

You just gotta look past the word FREE!!!

So let’s click on those fee links in the smaller, fainter font to find out how zero commission brokers make their money.

Zero commission is freemium

A freemium pricing model gives away a basic service for nothing. Some customers keep the business afloat by paying for extra features.

That’s a reasonable explanation of how free trading platforms work. That, plus the finance industry’s habit of hiding costs in plain sight.

Zero commission brokers are regulated, so they will tell you somewhere how they make their money.

But you might sometimes need the persistence of Columbo to dig it out of information architecture that’d befuddle Escher.

One way to find out how a trading app makes money is to ask them.

Google: How does [insert zero commission broker name] make money?

From there we can follow the breadcrumbs.

Each operator exploits a slightly different niche. When choosing a free trading platform your goal should be to pick a broker that serves your needs but doesn’t harpoon you like a whale.

Swim away from operators who make most of their profits by exploiting your investing habits.

Hooked

Talking of things that are a bit fishy, we need to delve into the bait-and-switch tactics used by some trading platforms.

Or, as it’s more politely phrased in Powerpoint presentations around the world: “cross-sell / upsell”.

The Financial Times wrote a good piece on zero commission brokers. It asserts the free trading part is just bait on a hook.

The argument is that 0% commission stocks are designed to reel you in as surely as the bright lights of a Vegas casino.

But the real profits are made on other financial instruments.

That would explain why some free trading apps dazzle with ‘Bet now!’ opportunities on Contracts For Difference (CFDs), crypto, and foreign exchange.

Higher spreads

Trading 212 for one will happily tell you that its main gig is CFD trading.

Its ‘How does Trading 212 make money?’ page states:

Our platform is making money from its CFD business, where the main revenue comes from the spread and the interest swap.

The spread is the difference between the price you pay for a financial instrument versus the lower price it’s sold for.

As with buying foreign dosh for holidaying abroad (remember that?), the intermediary pockets some of the spread for making the deal happen.

There’s nothing intrinsically dodgy about this. It’s just useful to know:

• It’s the spread on CFDs and not stock trading that’s the main source of profit here.
• Zero commission does not mean free.

We’ll come back to the interest rate swap business in a sec.

Same difference?

Elsewhere, the typographically-curious eToro does not publish a ‘How does eToro make money?’ page.

But eToro cites the spread as a charge on the CFD and crypto tabs of its fees page.

eToro’s partners programme also pays affiliate commission on spread revenues generated by customers’ trading (minus eToro’s expenses).

On page seven of its terms and conditions document – in the Conflicts of Interest section – eToro states:

We are responsible for setting the price of instruments and products which can be traded on the eToro platform.

This means that our prices will be different from the prices provided by other brokers and the market price, as well as the current prices on any exchanges or trading platforms.

On page 30 of its T&Cs eToro explains that it controls the spread for CFDs…

…with respect to CFD trading: (a) we set both the sell price and the buy price of CFDs, both of which are quoted on our platform.

…whereas it notes on the 0% Commission Stocks/ETFs section of its fee schedule PDF:

This spread is determined by the market and not by eToro.

eToro doesn’t mention the spread as an explicit charge on the stocks tab of their fee page, but it does for CFDs and crypto.

That might suggest that at least some zero commission brokers aren’t profiting much – if at all – from stock trading spreads.

Spreading the net wider

I read another good piece that tested whether spreads for stocks are wider with commission-free brokers than traditional investing platforms.

The author struggled to pin down exact spreads due to a lack of transparency from some zero commission brokers. But they concluded that stock spreads probably weren’t unusually wide on free trading platforms.

That’s because the price paid per share was similar to other online brokers.

It’s worth mentioning you can’t test this with just a few test trades. Wider spreads show up in aggregate rather than on every transaction.

An individual may barely notice a penny or two spirited away occasionally, just as a mosquito sneakily siphons off a few drops of blood.

This product may damage your wealth

The FCA requires CFD platforms to display warnings about how many retail investors (that’s you and me) lose money trading such instruments.

Trading 212 says 68% of retail investor accounts lose money when trading CFDs on its site. (At the time of writing).

And eToro also says 68% of retail investor accounts lose money when trading CFDs on its site. (At the time of writing).

Consistent and perhaps disturbing, huh?

Meanwhile, eToro adverts now follow me around the internet trumpeting the platform’s social trading technology.

This feature enables customers to automatically copy the moves of top-performing traders on eToro.

Great idea. What could make more sense to a beginner? Just mimic the experts and you’re golden!

Except we know it’s extremely hard to pick winners in investing.

What’s even less obvious from the ads is:

• If a large chunk of eToro’s profits are from CFD trading then it could be that many of their investors are also into CFD trading.
• If I copy their CFD trades then I also pay CFD fees. Automatically.
• Remember, 68% of retail investors are losing money in CFDs.

Overnight fees

CFDs are a financial derivative that enables you to make a leveraged bet on the price movements of underlying assets such as crypto, currencies, commodities, and stocks.

eToro charges fees to finance your CFD position if you leave it open overnight or at the weekend.

Trading 212 does the same but calls it an interest swap.

You can avoid the charge by closing your position before the platform’s daily deadline or, alternatively, by not trading CFDs.

Currency conversion fees

Some zero commission brokers make money by charging above the spot price for currency conversion.

These fees are triggered when you trade instruments priced in US dollars, for example.

You can avoid excess currency conversion fees by:

• Trading in GBP-denominated assets.
• Choosing a broker that charges the spot price for foreign exchange (FX) – or very close to it.
• Using a broker that enables you to hold multiple currencies in your account.

Freetrade, Trading 212, Revolut, and eToro all charge currency conversion fees in various scenarios.

In the case of eToro and Revolut accounts, you can only trade in US dollars. So you pay currency conversion fees to deposit and withdraw pounds.

Interest rate arbitrage

This next one is a nice little earner that’s easy to overlook in our age of near-zero interest rates.

Customers park cash in their stock brokerage account where it earns nothing. The broker then sweeps the cash to more profitable locations.

It could be temporarily stored with their own banker or popped into a money market fund – anywhere that earns a smidge more interest than the broker pays its customers.

Do that at scale and suddenly interest gets interesting.

I don’t think this one is particularly an issue with commission-free brokers, mind. It’s an age-old industry-wide practice.

But clearly this is an income stream that benefits from scale. That’s typically achieved when your offering achieves mass adoption – say because it’s free, or feels like it is.

Cash withdrawal and deposit charges

Some zero commission brokers explicitly charge to deposit or withdraw money from your account. Maybe with an FX conversion fee tacked on because they only deal in dollars.

It’s an odd charge in the age of electronic money, but I’ve no issue with it because it’s completely transparent and therefore you can manage it.

Premium services

It’s a bit old skool but zero commission brokers may also charge a set price for a given service you might like.

According to Freetrade’s ‘How does Freetrade make money?’ page, this is how it earns most of its corn.

You might pay it a platform fee for an ISA or a SIPP. Or maybe you’ll pay a subscription fee for a better service than the freebie account.

Freetrade Plus lets you play with a wider choice of stocks, ETFs, and order types, for example.

Fine – there’s no more mystery to that than you see with a premium bank or Spotify account.

Sometimes you really do get what you pay for.

Payment for order flow

Payment for Order Flow typically occurs when a broker directs orders from its customers to a favoured market maker who then executes the trades.

The broker does this because it’s handsomely rewarded by the market maker for all that lovely business.

The FCA banned payment for order flow in the UK. The FCA believes such kickbacks create a conflict of interest between brokers and customers – specifically in the form of wider spreads than you’d pay for ‘best execution’ in the open market.

FCA-regulated brokers are obliged to obtain best execution for UK customer’s orders. As opposed to funneling trades to whoever pays the chunkiest backhander.

Infamously, the trailblazing zero commission broker Robinhood makes money in the US from payment for order flow.

It’s worth noting that difficult-to-dupe passive investing champion Larry Swedroe for one believes the payments – combined with low or no commission fees – may indeed reduce costs for ordinary investors.

In any event, the FCA’s 2019 paper on the practice noted some UK brokers outsourced orders to overseas affiliates that still took payment for order flow.

The FCA added that this workaround is still deemed a conflict of interest.

Its report further mentioned that the FCA:

…expect firms to consider the findings of this report and improve their practices.

All very British and understated.

Let’s hope the FCA’s disapproval shames any miscreants into compliance, lest they not be invited to the next Christmas party.

It’s a free country

The good news is zero commission brokers aren’t going to starve because of their 0% fee generosity.

So if you like their services, you needn’t fear they’re unsustainable.

Indeed, they have even more revenue streams to wash their face with. There’s securities lending, rehypothecation, inactivity fees, and hedging against the trades of their own customers.

Not all the free trading platforms tap into all the money-making schemes discussed in this article.

But it’s useful to know what to look out for.

As I said earlier, different trading platforms target different market niches.

The right choice for you may be one that doesn’t profit excessively from your specific investing foibles.

For instance I don’t trade much, so I don’t care about zero commission. But I do need a SIPP.

Together that means I’m probably best off with a broker that’ll provide a SIPP for a low platform fee. I can take the occasional hit on dealing fees.

Costs and consequences

As a group, retail investors lose money the more they trade.

Perhaps zero commission is not an absolute no-brainer then – even if it’s close to free – if it encourages more trading?

That’s something else to think about.

Ultimately, zero commission brokers know what they’re doing. What we care about is that the investing public does, too.

Take it steady,

The Accumulator

P.S. Make sure that your investments and cash are protected by the Financial Services Compensation Scheme. Your broker must be authorised and regulated by the FCA (or PRA) for the specific service or product you use.