Wall Street has become computerized. A large percentage of trading volume is automated, being either passive or algorithmic. Very few humans stay on the NYSE floor, and trading continues as normal through New York’s quarantine. Nasdaq never even had humans on its floor.
Like in other industries, computers have cut out the middleman in stock sales to ordinary people, who tend to trust their own judgment over that of a salesperson. However, for the longest time, you still had to pay commission and other brokerage fees on the buying/selling of assets. After all, somebody has to pay for the server running the trading window, customer service staff, and exchange fees. Besides, why would brokers lower their prices if rich traders are willing to pay?
Recently, though, that’s been changing. More and more brokers are offering commission-free trading and free accounts. That’s right: just like big tech and social media companies, they offer you something for nothing. How do they make money? More importantly, how are they screwing you?
Though traditional brokers have also recently moved to zero-commission, the most famous zero-cost exchange is Robinhood. Surprisingly, they’re very open about how they make money[1]. Even more dazzling is the fact that all of this is mutually beneficial. There is no catch.
Most of Robinhood’s revenue streams are boring: they make interest on free-floating cash in customers’ accounts, they sell a premium service for a monthly fee, and they profit from repo-style loans of margin-traded securities. None of that really hurts you unless you count the opportunity cost of liquid cash, or the entire American financial system goes belly-up.
There’s another, more interesting thing going on as well. Robinhood, TD Ameritrade, Charles Schwab, etc, don’t actually send your trades to stock exchanges. Instead, they send them to “Market Makers”[2]. Market makers basically function like mini-stock exchanges, quoting a buy and sell price with a spread in-between. That spread is often smaller than on the exchange, which attracts buyers and sellers, and the market maker profits from the bid-ask spread as they match buyers and sellers[3]. This is all done algorithmically at extremely high speeds and low latencies, completely transparent to the average trader.
In this situation, everybody is scratching each-others back. Average joe traders like you and me get the benefit of faster order fills and tighter bid-ask spreads. The market makers get access to order flow that they know isn’t coming from a competitor’s algorithm trying to profit off of information the market maker doesn’t have (this is called “adverse selection”[4], and is a PhD-worthy topic on its own). Thus, they can safely make money on their bid-ask spread. The brokers give us a nice trading interface, and they make money selling our orders to market makers, who pay them a small fee for doing so.
There are also laws in place to protect the average investor from predatory practice: market makers and brokers are required to quote a price that’s at least as good as the exchange itself[5].
Everybody profits from the increased efficiency provided by market makers. Competition. Capitalism. America.
[1] https://robinhood.com/us/en/support/articles/360001226106/how-robinhood-makes-money/
[2] https://www.cnbc.com/2019/04/18/a-controversial-part-of-robinhoods-business-tripled-in-sales-thanks-to-high-frequency-trading-firms.html
[3] https://www.investopedia.com/terms/m/marketmaker.asp
[4] https://medium.com/hyperquant/inside-quant-trading-the-market-maker-algorithm-80ffda0f17f
[5] https://www.schwab.com/public/schwab/active_trader/trading_tools/execution_quality/price_improvement
This is a very informative article! As someone who doesn't understand stock trading too much, I'm not really sure what the market makers are with your explanation? And how is Robinhood allowed to make money off interest from free-floating cash in customer's bank accounts.
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