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I know that this question has been hinted at on other open question sites like Quora but I have yet to find anyone who lists all of the points in one place.

I understand that firms make money by:

  • Commission and fees - Charging investors a fee to buy/sell securities.
  • Interest on idle cash - Accruing interest from investor's money.
  • Interest on cash lent in margin account - Charging interest on the borrowed money in a margin account.
  • Fees charged for short selling - Charging the investor for the securities that have been lent.
  • Payment for order flow - Market makers pay the brokerage firm for the right to transact with the firm's clients. Assuming the firm itself is not a market maker.
  • Exchanges pay firm for liquidity - Exchanges where the buying/selling of securities are taking place, pay the firm for providing traffic so to speak.

I have two questions?

  1. Did I miss any, are there any other ways that I missed that brokerage firms make a profit?
  2. How is interest accrued on on idle cash? Is it invested by the firm in the background in low-risk securities that pay a premium? Or in low-risk government bonds? How??

Any advise, direction, or links to blogs or books would be greatly appreciated.

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    This isn't really a personal finance question, unless you refocus it on where a broker's interests may conflict with those of their customers and what to watch out for...
    – keshlam
    Commented Feb 5, 2017 at 3:27

1 Answer 1

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Regarding "Interest on idle cash",

brokerage firms must maintain a segregated account on the brokerage firm's books to make sure that the client's money and the firm's money is not intermingled, and clients funds are not used for operational purposes.

Source.

Thus, brokerage firms do not earn interest on cash that is held unused in client accounts.

Regarding "Exchanges pay firm for liquidity", I am not aware of any circumstances under which an exchange will pay a brokerage any such fee. In fact, the opposite is the case. Exchanges charge participants to transact business. See : How the NYSE makes money

Similarly, market makers do not pay a broker to transact business on their behalf. They charge the broker a commission just like the broker charges their client a commission. Of course, a large broker may also be acting as market maker or deal directly with the exchange, in which case no such commission will be incurred by the broker. In any case, the broker will pay a commission to the clearing house.

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  • Yep. Commissions and fees are most of it, I believe.
    – keshlam
    Commented Feb 5, 2017 at 15:00
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    You should read the book Flash Boys, there are exchanges that have fee structures that essentially pay for liquidity.
    – quid
    Commented Feb 5, 2017 at 19:59
  • @quid Interesting. I've heard of the book, but I haven't read it. These would be the virtual exchanges I assume.
    – not-nick
    Commented Feb 5, 2017 at 22:26
  • I saw a recommendation for it on here actually and read it. It was eye-opening.
    – quid
    Commented Feb 5, 2017 at 22:32
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    Brokers that own a bank can store their client's money at their bank. This means the bank can use it to earn money through loans and interest, and it muddles the rules around segregation of client and broker's monies. Basically the bank acts like a 3rd party that doesn't care whose money it's lending out or investing from a legal standpoint. Since the bank is owned by the broker, the bank's profits are de facto the broker's profits.
    – Marshall Tigerus
    Commented Feb 6, 2017 at 15:06

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