What it means
At its core a brokerage is an agent. It does not generally want to own what you are buying; it wants to match you with a counterparty, execute the order and take a slice of the transaction for the service.
The business model has shifted a long way over the past two decades. Headline trading commissions have fallen towards zero at many retail firms, so revenue increasingly comes from advisory fees charged on client assets, interest earned on client cash, margin lending and payments for routing order flow.
Brokerages fall into three rough groups. Discount or execution-only firms give you a platform and little else, full-service firms add advice and planning for a fee, and prime brokers serve hedge funds with financing, custody and settlement.
For a business audience the practical points are custody and regulation. Client assets are meant to be held separately from the firm's own money, and in the United States accounts carry investor protection scheme cover up to set limits, which is protection against the firm failing rather than against investments falling.
A frequent confusion is between a broker and a dealer. A broker acts for you and charges a commission, whereas a dealer trades from its own inventory and earns the spread between what it pays and what it sells for, and many firms do both under a single broker-dealer registration.
In practice
Real-world examples.
Example
A software startup with $4,000,000 of cash from its Series A opened an account with a brokerage company to build a short-dated treasury bill ladder. The finance lead chose a discount firm because the company needed execution and custody, not advice, and the annual cost came to a few hundred dollars.
Example
A 900-employee engineering group appointed a brokerage company to administer its employee share purchase plan. The firm handled payroll deductions, quarterly purchases and the sale instructions employees submitted, which removed a recurring administrative burden from the payroll team.
Example
A small charity's investment committee compared a full-service brokerage charging 1% of assets with a discount platform charging almost nothing per trade. It chose the full-service firm because the committee met only twice a year and wanted a named adviser accountable for the portfolio between meetings.
Formula
Calculation
A brokerage has no defining formula, but its revenue is usually the sum of three streams:
Revenue = Commissions + Asset-based fees + Net interest income
Take a mid-sized brokerage over a single quarter. Clients place 250,000 trades at an average commission of $4.95, giving 250,000 x $4.95 = $1,237,500.
The firm also advises on $1,200,000,000 of client assets at an annual fee of 0.75%. That is $1,200,000,000 x 0.75% = $9,000,000 a year, or $9,000,000 / 4 = $2,250,000 for the quarter.
Finally it holds $300,000,000 of client cash and earns a 2% annual spread on it: $300,000,000 x 2% = $6,000,000 a year, or $1,500,000 for the quarter.
Total quarterly revenue is $1,237,500 + $2,250,000 + $1,500,000 = $4,987,500. Commissions are only $1,237,500 / $4,987,500 = 24.8% of that total, which explains how a firm of this shape can afford to cut trading fees to nothing and still grow.Case study
Seen in the real world.
Marlowe and Vance Securities is an illustrative brokerage invented to show how the economics have changed. For most of its history it charged $19.95 a trade, and commissions produced the large majority of its revenue.
When competitors moved to zero commission, the firm's leadership initially resisted, calculating that matching the move would wipe out about $14,000,000 of annual revenue. A closer look at the numbers showed that the accounts placing the most trades also held the largest uninvested cash balances and were the most likely to take margin loans, both of which earned money regardless of what the firm charged per trade.
Marlowe and Vance cut commissions to zero, lost the revenue it had predicted, and recovered most of it within two years through higher account balances, advisory fees on a new managed portfolio service and net interest on client cash. The fictional case is a reminder that a brokerage company is a bundle of related revenue lines, not a per-trade toll booth.
Watch out
Common mistakes.
- Assuming a zero-commission brokerage is free, when the firm still earns money from cash balances, order flow payments, currency conversion and margin interest.
- Confusing the brokerage with the investments held inside it, so that a client worries about the firm's share price rather than the assets in their own account.
- Believing investor protection scheme cover compensates for market losses, when it only applies if the brokerage itself fails and client assets are missing.
Questions
People also ask.
What is the difference between a broker and a broker-dealer?
A broker acts purely as an agent for clients, while a broker-dealer is registered to do that and also to trade for its own account, which most sizeable firms do.
Does a brokerage company own my shares?
The shares are usually held in street name for administrative reasons, but they remain your property and are recorded as belonging to you in the firm's books.
How do I compare brokerage costs?
Look past the headline commission at platform fees, currency conversion charges, margin rates, inactivity fees and the interest paid on your idle cash.
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