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How do brokers make money when they lend customers money to trade on margin?

Let's say someone deposits $30,000 into an account and is given power to purchase $60,000 worth of securities.

The person purchases 6,000 shares of company XYZ at $10 per share, totaling $60,000.

How does the broker make money in this situation?

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2 Answers 2

They will make money from brokerage as usual and also from the interest they charge you for lending you the money for you to buy your shares on margin. In other words you will be paying interest on the $30,000 you borrowed from your broker.

Also, as per Chris's comment, if you are shorting securities through your margin account, your broker would charge you a fee for lending you the securities to short.

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Exactly. They make money on the interest and on the increased trading activity that having access to margin tends to encourage. –  QuantumMechanic Mar 23 at 23:51
    
You might want to mention securities lending as well [I expect the broker makes additional income from it?] as QuantumMechanic mentioned at this other question: money.stackexchange.com/questions/9481/… –  Chris W. Rea Mar 24 at 1:29
    
@ChrisW.Rea Good point: that is often the main source of the broker's income from leveraged positions! –  assylias Mar 24 at 10:56
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Your broker will charge you commissions and debit interest on your "overdraft" of $30,000. However it is very likely that your contract with the broker also contains a rehypothecation clause which allows your broker to use your assets. Typically, with a debt of $30,000, they would probably be entitled to use $45-60,000 of your stocks.

In short, that means that they would be allowed to "borrow" the stocks you just bought from your account and either lend them to other clients or pledge them as collateral with a bank and receive interest. In both cases they will make money with your stocks. See for example clause #14 of this typical broker's client agreement.

Applied to your example:

  • they will receive 1c/share of commissions (less some small exchange/clearing fees) = ca. $60 for the transaction
  • they will charge you 1.5% interest (if you have good financing terms!) on your $30,000 debit balance
  • they will lend your stocks to someone who wants to short them and receive 3% interest (that's a random number - it can can vary wildly from < 1% to 40%+)

In other words they will make $60 + $450 + $1,800 = $2,310 the first year. If the stock is expensive to borrow and they manage to lend it, they will make a lot more.

There are by the way a few important consequences:

  • you may not be able to vote on those shares (because you don't technically own them any more)
  • you have a counterparty risk with your broker: if they default you may or may not recover the stocks they have borrowed from you. Depending on your jurisdiction, a financial loss due to the brokers defaulting may or may not be insured.
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