The rise of discount brokerages has redefined the way people invest, offering flexible and practical trading platforms to millions of individuals. The promise of commission-free trades and user-friendly tools has allowed self-directed investors to take charge of their financial futures. 

But how do these platforms sustain their operations while offering low-cost services? Behind the scenes, discount brokers leverage innovative revenue models, ranging from payment for order flow to securities lending, to keep their services running. 

This guide will unravel how discount brokerages make money while empowering their clients.

Key Takeaways

• Discount brokerages earn revenue from innovative methods like PFOF, margin lending, and securities lending, ensuring profitability without direct trading commissions.

• Subscription-based premium services and asset management fees from robo-advisory platforms provide scalable, high-value revenue streams for these brokers.

• Idle cash in client accounts generates substantial income through interest on investments, with aggregated funds adding significant profitability during high-rate periods.

What Are Discount Brokerages?

A discount brokerage is a type of financial services firm that allows investors to trade securities at lower costs than traditional full-service self-directed trading. They cater to cost-conscious investors who prefer brokerages. Unlike full-service brokers, who offer a wide array of personalised advisory services and portfolio management, discount brokerage companies focus primarily on providing platforms for managing their investments without paying for extensive advisory services.

Discount brokerages have gained significant popularity, especially with the rise of online trading platforms and mobile apps. They provide users access to stock markets, exchange-traded funds (ETFs), options, and other financial instruments at minimal fees. This affordability has made them a go-to option for retail investors, empowering individuals to take charge of their financial goals with low barriers to entry.

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Fast Fact

Payment for order flow (PFOF), a major revenue source for discount brokerages, was first introduced in the 1980s by Bernard Madoff's firm as an innovative way to monetise trade execution.

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Key Features of Discount Brokerages

The hallmark of a discount brokerage is its low-cost structure. Many discount brokers now offer commission-free trading, eliminating the fees traditionally associated with buying or selling securities. Instead of charging per transaction, these brokers often generate revenue through other means, such as payment for order flow, interest on idle cash balances, and optional premium services.

Most discount brokerages operate through intuitive online platforms or mobile apps, providing users with trading tools, tracking portfolio performance, and accessing basic market research. While they lack the hands-on advisory services of full-service brokers, they cater to investors confident in making their own investment decisions or looking to save on fees.

Advantages of Discount Brokerages

The main advantage of using a discount brokerage is the cost savings. By offering low or no trading commissions, these brokers make it easier for small-scale or beginner investors to participate in the markets. Furthermore, their platforms are often user-friendly and equipped with features like real-time stock quotes, technical analysis tools, and educational resources to help investors make informed decisions.

Another benefit is the flexibility they provide. Investors can fully control their portfolios, tailoring strategies to their financial goals and risk tolerance. This autonomy particularly appeals to those who prefer a DIY (do-it-yourself) approach to investing.

 How Discount Brokerages Make Money?

Discount brokerage firms have revolutionised investing by offering low-cost or commission-free trading to clients. While they charge little or no fees for executing trades, they still generate revenue through various channels. 

Here are the primary revenue streams that enable discount brokerages to sustain and grow their business:

Payment for Order Flow (PFOF)

PFOF is a significant revenue source for many discount brokerages. When clients place a trade, the brokerage does not directly send the order to a stock exchange. Instead, it routes the order to a market maker or a high-frequency trading (HFT) firm. In exchange for routing these orders, the market maker pays a fee to the brokerage.

Market makers execute trades and earn profits from the bid-ask spread — the difference between the price they are willing to pay for a security (bid) and the price they are willing to sell it for (ask). To encourage brokerages to send orders their way, market makers share a portion of their profits as a payment for order flow. This arrangement enables discount brokers to generate revenue without charging their clients a direct commission for executing trades.

Interest on Client Balances

Many discount brokerage clients leave uninvested cash in their accounts as a reserve for future trades or as part of their portfolio strategy. Discount brokers generate substantial income by investing this idle cash into low-risk, interest-bearing financial instruments like money, market funds or Treasury bills.

When a client holds $10,000 in uninvested cash in their discount brokerage account, the brokerage invests that money and earns interest. However, the brokerage retains most of the yield and typically shares only a small portion — or none — with the client.

With millions of customers, the aggregate uninvested cash held by clients can amount to billions of dollars, creating a significant income stream. This revenue becomes even more substantial during periods of higher interest rates, as brokers can earn greater returns on their investments.

Margin Lending

Margin lending is a consistent and predictable revenue source for discount brokerages. Brokers earn interest on these loans by allowing clients to borrow money to trade larger positions than their account balances would otherwise allow.

For example, if a client has $20,000 in cash and borrows an additional $10,000 on margin to increase their trading power, the brokerage charges interest on the $10,000 loan. Interest rates for margin loans vary but generally range between 5% and 10% annually, depending on the amount borrowed and market conditions.

Margin lending is particularly lucrative during periods of high market activity, as clients are more likely to leverage borrowed funds to maximise their potential returns. This consistent cash flow helps brokers maintain steady revenue, even when other income sources fluctuate.

Subscription-Based Premium Services

Discount online brokerage offers optional premium features or services that cater to advanced investors or traders who seek enhanced tools and data. These services are typically offered on a subscription basis.

Examples of premium offerings:

• Advanced charting tools for technical analysis.

• Access to in-depth market research and reports.

• Faster order execution or priority customer support.

• Customisable trading platforms with additional analytics.

Clients pay a recurring monthly or annual fee to access these services. For example, a brokerage might charge $50 monthly for a premium package with advanced trading tools and exclusive market insights. This revenue stream helps brokers cater to high-value clients while diversifying their income sources.

Securities Lending

Securities lending is another profitable avenue for discount brokerages. Brokers lend out securities held in their clients' portfolios to other market participants, such as short-sellers or institutional investors, in exchange for a fee.

When a client owns shares of a stock, the brokerage can lend those shares to another party. The borrower pays a lending fee, and the brokerage retains most of the income generated from the transaction.

Although clients retain ownership of the shares, they may sometimes lose certain benefits, such as voting rights during shareholder meetings or the ability to sell the shares immediately. However, securities lending allows brokers to monetise client holdings without directly affecting the client's portfolio performance.

Advertising and Partnerships

Discount brokers monetise their platforms by displaying advertisements or forming strategic partnerships with financial product providers.

Examples of partnerships:

Promoting specific mutual funds or ETFs and receiving a fee from the fund provider.

Collaborating with financial institutions like credit card companies or banks to cross-promote their products.

Brokers display targeted ads or sponsored content on their platforms, leveraging their large user base to generate advertising income. For example, they might feature advertisements for insurance products or investment courses relevant to their audience.

Asset Management Fees

Some discount brokers provide robo-advisory or automated portfolio management services as an optional offering. These services use algorithms to create and manage diversified portfolios based on the client's risk tolerance and financial goals.

Clients pay an annual fee ranging from 0.25% to 0.50% of their total assets under management (AUM). For instance, if a client has $100,000 managed by the brokerage's robo-advisory service, they would pay $250 to $500 annually.

Automated services require minimal human intervention, making them highly scalable. As more clients opt for low-cost portfolio management, brokers can generate significant revenue with relatively low operational costs.

Account-Related Fees

Although many discount brokers advertise "no fees," they still" charge "certain account-related services or transactions.

Examples of fees include:

• Wire transfer fees for moving funds between accounts.

• Charges for paper statements or physical trade confirmations.

• Inactivity fees for accounts that do not meet minimum activity thresholds.

These seemingly small fees can add significantly, especially for brokerages with a large customer base. While clients may not notice these charges individually, they represent a consistent revenue stream for brokers.

Conclusion

Discount brokerages have redefined the investment landscape by making trading transparent and reasonably priced for all. While their commission-free model benefits investors, their innovative revenue streams ensure profitability and growth. From payment for order flow to premium subscriptions, these brokers have found diverse ways to thrive in a saturated market. 

As the industry continues to evolve, transparency and innovation will remain key to maintaining trust and success. Understanding how discount brokerages make money empowers investors to make informed choices and maximise their financial strategies.

FAQ

How do discount brokerages carry out commission-free trading?

They generate revenue through methods like payment for order flow, securities lending, and interest on idle cash balances, offsetting the lack of trading fees.

What is payment for order flow (PFOF)?

PFOF is when brokers route client trades to market makers or high-frequency trading firms, who pay the broker for directing the orders to them.

Do discount brokerages charge any hidden fees?

While many advertise "no fees," they may charge for specific services like wire transfers, account inactivity, or paper statements.

What are premium subscription services offered by discount brokers?

These include advanced trading tools, real-time analytics, faster trade execution, and in-depth market research for a monthly or annual fee.