Over the period of lockdowns - a time when money and time were uniquely freed up for millions - retail investing took off. Amateur traders and DIY traders were seriously increasing in their numbers, and were touted as being a reason behind the V-shaped recovery in 2019 and generally reducing crash risk.
A brokerage business sounds like quite the undertaking, but there are more smaller brokers that continue to crop up in the market. It appears that DIY investors prefer fintech startups over large traditional brokers, as the latter often use sluggish legacy systems and over-the-top security features. For example, signing up to Robinhood is much faster than at the likes of Degiro because their infrastructure and KYC model is much more lightweight.
Success stories like Robinhood show the eye-watering levels of rapid growth as they captured the rise of retail investment. Robinhood was launched in 2015 and is already worth $8 billion. And, the likes of Robinhood thrived despite the poor economic environment during 2019. This isn’t a one-off phenomenon driven by retail investors though, because brokers appear to be recession-proof even in the most desperate of times.
IG Index is a good example of how a broker remains profitable during a recession, as their profits rose from £70 million to £98 million from 2007 to 2008. In fact, the dividend per share also increased from 6.5p to 9.0p during what was not only the greatest crash of our lifetime, but severe enough to be a threat to capitalism itself. They weren’t the only ones either, as Charles Schwab saw revenue grow from 2007 to 2008 too.
How exactly do brokers make money?
A brokerage as a business model traditionally made their money on the commission of each trade. But, the other reason not mentioned yet behind the growth of this "discount" DIY stock brokers model is because they are commission-free. And, for retail investors just starting out, it’s very difficult to be persuaded to join any company that isn’t free of commission when many are. As a result, almost every broker now offers commission-free trading for stocks. So, how do brokers make money?
Brokers are there to connect their clients to their market; so, they can make a deal happen on the NYSE for their customers. They used to ask for a fee for each transaction made by the customer and receive the money for the order and place the order for them. For example, a 1% fee or a fixed price like $5.
This model holds true for many trades still, but just not stocks and often ETFs. However, other trades like Options, futures, bonds, forex, and mutual funds often incur a transaction fee commission, which is still a major way of generating revenue.
Another way of generating revenue is through the spread; when the buy price is higher than the selling price then there is a discrepancy. The additional point that is added onto the natural spread is very similar to taking a commission, but it’s better for marketing to mention the free commission because the spread is included in the buying price.
The natural spread is low anyway because of the introduction of high-frequency trading. Because even amateur traders now have access to good technology, there are simply more trades going on at any given time. The more trades there are, the more liquidity there is, which generally suppresses the spread.
Finally, money is generated through other means too, much like a low-cost airline recouping money in the add-ons during a purchase. Premium memberships are usually on offer, which can gain access to better researching and charting tools, as well as charging for withdrawals, deposits, earning interest on clients’ cash balances, advisory services, and stock loans.
DIY traders are more than happy to try out new licensed startups that make trading even more convenient for them. Data visualization, integration with other apps, and social features are some of the ways to get an advantage in the marketplace. For more information on how to register and become a broker-dealer in the US, check the U.S. Securities and Commision website.
However, keeping pricing as simple and transparent as possible is increasingly respected by users. As mentioned earlier, low-cost airlines frequently use sneaky ways to add-in things towards the end of the sales funnel. Some fees like inactivity and withdrawal fees are not appreciated by retail traders because these fees hit “low rollers” hardest - a $10 withdrawal fee is really felt by a beginner who is only withdrawing $50. Likewise, they are most prone to being inactive. So, matching up where revenue streams come from with the needs of the demographic becomes important in winning over the online reviewers who have a lot of power and influence.