A retail broker such as Fidelity, Charles Schwab, Vanguard, Robinhood, tastyworks, Interactive Brokers etc. enables everyday people to participate in the financial markets.
Like any successful business these institutions are first and foremost designed to generate revenue. Similarly, like any successful business they also have risks inherent to their business model.
Let’s take a look at the retail broker business model, highlight their revenue streams and understand their risks and mitigation strategies.
Once we’ve laid out the business model let’s see if there’s an optimal approach to utilizing retail brokers to participate in the financial markets.
To help us understand the business model of retail brokers it’s beneficial to have an understanding of how they’re positioned in the financial industry.
As it relates to the retail broker business model, there are 5 main entities in the financial industry:
- Investment Banks
- Retail Brokers
- Trading Educators
- Retail Traders
This is where companies list their shares for trade. When a company decides to have an initial public offering (IPO) one of the decisions it must make is on what exchange to list its shares.
There are three main players in the exchange space:
- Intercontinental Exchange (ICE)
- New York Stock Exchange (NYSE)
- Euronext (NYX)
- Chicago Mercantile Exchange (CME)
- Chicago Board of Trade (CBOT)
- New York Mercantile Exchange (NYME)
- Commodity Exchange (COMEX)
- Nasdaq, Inc
- Nasdaq Nordic (formerly OMX)
- Nasdaq Baltic
Exchanges make the bulk of their money through three channels.
Listing fees – organizations that list shares on an exchange are charged an annual listing fee.
Trading fees – these are costs assessed when transacting on the exchanges. The primary customer of exchange trading fees are investment banks.
Market data access – exchanges capture data relating to pricing, volume, queue depth, greeks, etc. that happen on their platform(s) and sell that data as real-time market data subscriptions, historic data (think options pricing), etc. Any instance of a real-time data source, whether at a retail broker or otherwise, is paying fees to exchanges for this data.
Since everything is fee and subscription based the largest risk is a new player undercutting costs. The history of ICE, CME and NASDAQ includes an extensive list of mergers and acquisitions in order to keep the status quo.
IEX is a relatively new exchange looking to shake up the industry and currently lists Interactive Brokers (IBKR). They are undercutting the incumbents on listing and trading fees and giving away their market data for free. In fact, I’m using their API to populate dividend data, data that’s not available using Google Sheets’ finance functions, in my personal spreadsheets.
Investment banks are the primary consumers of exchange resources. If you’ve ever looked up a stock and saw a stat called “Shares Held by Institutions,” these are the entities holding those shares (the balance of those shares are held by non-institutional traders such as retail traders).
In the investment bank space you’ll find JPMorgan Chase, Goldman Sachs, Credit Sussie and more.
Hedge funds, pension funds and high-frequency traders (HFTs) are peers of investment banks when it comes to customers of exchanges, but they typically don’t participate in the lending and underwriting activities of investment banks.
For our purposes of highlighting the role investment banks play in the retail broker business model we will focus on their deep pockets. In particular, the investment bank’s provision / extension of credit to retail brokers.
These are businesses that provide non-professional traders access to financial markets.
To aid in their marketing efforts, retail brokers may solicit the assistance of trading educators to gain new clients.
We’ll do a deep dive on retail brokers in the next section.
These are businesses that provide marketing for retail brokers and train non-professionals how to trade.
The core tenet of trading educator operations is the IB (introducing broker) agreement. An IB agreement is a formal contract between the retail broker and the educator that defines the compensation the trading educator will receive from the retail broker for referring a retail trader.
Compensation models may consist of a flat referral bonus to the trading educator when the retail trader opens an account (common in the US) and/or a share of the commissions that account generates over a period of time (common outside the US; 20-50% commission share).
Genuine educators are regulated and are legally obligated to provide a copy of their IB agreement(s) when asked. Since it outlines how the educator is compensated it allows retail traders to identify potential conflicts of interest.
These are the non-professional traders that utilize retail brokers to gain access to the financial markets.
If we were to draw a simplified value chain of these five entities it might look something like this:
Traders fall into one of two buckets: institutional or retail.
This is where we find traders employed by investment banks. A “typical” trader at one of these institutions may structure their trading accordingly:
- Get rich slowly
- Builds a portfolio of positions
- Trades primarily on fundamentals
- Reasonable / realistic return expectations
- Defined portfolio volatility target (eg: 10% portfolio volatility)
- Investment Banks: 10-20 long / short positions (5%-10% portfolio/position)
- Hedge Funds: over 20 long / short positions (1%-5% portfolio/position)
- Targets are contractually set; institutional traders are hired on a mandate. Market outperformance is not typically the goal; outperformance at a specific risk / volatility target is the goal.
- Generally profitable
This is anyone that’s not a trader at an institution. A “typical” retail trader may structure their trading accordingly:
- Get rich quickly
- Day and swing trading
- Trades primarily on technical analysis and individual catalysts such as non-farm payroll data release
- Unreasonable / unrealistic return expectations
- Undefined portfolio volatility target / “whatever necessary to make money”
- Typically only 3 positions
- Forex pair
- Speculative short on SPY / long on VIX
- The latest meme stock (currently Micron [MU] or Tesla [TSLA])
- Various “bets” using options or CFDs
- Attempts to beat the market
- Generally unprofitable
This is a rule-of-thumb that states 90% of retail traders lose 90% of their capital in 90 days.
The capital isn’t actually “lost,” it’s transferred to the retail broker. Let’s find out how.
Retail Broker Revenue Model
There are multiple revenue streams available to retail brokers.
Frequency, Volume and Order Size
Simply put, the retail broker makes more money the more frequently and larger we trade by way of commissions and spreads.
A fee assessed for opening and closing positions. Some fees are per trade (frequency), some are per unit traded (volume) and some are on notional value of trade (order size).
- Ticket – 4.95 per trade or 0.005 per share
- Option – 0.70 per contract
- CFD (contract for difference) – 0.12% monthly trade value
A “hidden” fee derived from the bid / ask spread. Let’s use some visuals to depict what this looks like in practice.
Suppose we have two traders, John and Jane, both trading at the same retail broker. Jane sells one share of XYZ and John buys one share of XYZ, both at the same time using a market order. This is a synchronous buy / sell event. The transaction looks like this:
This is the ideal situation for retail brokers. There’s no risk. The position transfers from Jane to John in a single transaction and the retail broker makes the spread. However, in practice this is the exception rather than the norm.
Retail brokers, when they make markets, have to hold positions to allow time to find matching buyers and sellers. Not every buy / sell order has a matching counter order immediately available. The process looks like this:
The risk the retail broker faces in holding positions is that the positions may change in value beyond the width of the spread, potentially causing a loss.
The broker has a few tactics to alleviate this risk:
- Don’t hold the position to make a market; pass the transaction through to the exchanges where other market participants, including other brokers / market makers, can process the order.
- Vary the duration of time positions are held while waiting for a counter order
- Narrow or widen the bid / ask spread width
- Conditionally fill orders at or near the midpoint
- Limit market-making activities to specific positions or types of transactions / orders.
- Intentionally hold the position to take the other side of the trade then sell / buy it back for a profit on top of the spread (more on this in the next section).
Financing and OTC Gain
This stream revolves around leverage and the majority of trade types placed. Ever use margin or trade derivative products such as futures, options or CFDs? This covers those activities.
A “typical” retail trader after learning they can command 10k or more in assets while using only 2k of capital may attempt to “maximize capital efficiency” by allocating all their capital in the most leveraged way possible using CFDs, options, futures, options on futures, forex pairs, etc.
Where does this margin funding come from?
When the retail broker opened shop with, say, 50 million in starting capital they approached investment banks asking for a line of credit for, say, 250 million at an interest rate around the federal funds rate / LIBOR. The retail broker then offers this credit (leverage) to retail traders at a higher rate and makes the spread.
In doing this the broker transfers risk away from their capital and to the investment bank’s line of credit. It’s the investment bank’s money at risk, not the retail broker’s.
When the retail trader incurs an unmet margin call their positions are closed. This prevents losses from occurring on the retail broker’s line of credit.
In fact, during the negotiation process between the retail broker and investment bank your margin collateral is what’s used to back the line of credit.
In essence, by funding a margin account you’re enabling a retail broker to borrow money and lend it to you at a higher rate.
Short for over-the-counter gain, this is a fancy way of saying the retail broker takes the other side of your trade(s). The name came about due to CFDs being OTC products and the primary tool retail traders used to obtain leverage (before they were banned in the US after the GFC; they’re still allowed almost everywhere outside the US). That is, CFDs are contracts [for difference] between the retail trader and retail broker. They are not products traded on the market.
Using signals and other technical analysis are known by institutional / professional traders to be consistently unprofitable. Therefore, it is systematically profitable to take the other side of the retail trader’s trades with the assumption the retail trader is trading using technical analysis as a mechanic.
The same goes for event-based trading such as non-farm payroll reports. How can institutional traders consistently be right in a statistically significant way? Whisper numbers.
How exactly are retail brokers taking the other side of your trades? They acquire and hold positions then close them later and keep the difference as part of the market-making spread activity.
Therefore, by funding a margin account you are not only giving the retail broker credit to lend you money at a higher rate, you’re giving the retail broker credit to have the option to take the other side of your trades if you lose.
While writing this article I came across this handy warning label on Interactive Brokers’ UK site regarding CFD products:
Suppose you’re one of the retail traders that makes money.
Retail brokers sort retail traders into two buckets: those that are down and those that are up.
For those that are down it’s business as usual and the OTC gain is made using the mechanics of market making.
For those that are up the retail broker doesn’t make the OTC gain and instead hedges its market-making positions by using part of its credit line to “get neutral” with your positions while it continues to make markets.
Profitable retail traders cost retail brokers the OTC gain opportunity and force them to allocate twice as much capital (allocation for the leverage / margin used by you + allocation to get neutral on your positions).
This is of course all fully automated and the other revenue streams (commission, spread, financing) continue to be earned by the retail broker.
Payment for Order Flow
Retail brokers can choose to sell part or all of their order flow to 3rd parties, particularly to high-frequency traders (HFTs). HFTs are in the business of market making and exploiting arbitrage opportunities.
The process of routing order flow and receiving payment looks like this:
Below is a [non-inclusive] table that outlines which retail brokers participate in payment for order flow (PFOF) for equities and options as of June 20 2019.
To identify what each retail broker is receiving in compensation, review their quarterly SEC 606 Report. For example, here is Robinhood’s SEC 606 Disclosure. They are making $0.26 for every $1,000 in executed trade value from most of the orders routed. 19% of all orders routed were market orders.
Revenue Model Summary
Retail brokers can make money:
- Every time we trade with a flat fee
- Proportionally with the trade volume
- Proportionally with the notional trade value
- On the bid / ask spread
- On the margin interest spread
- By taking the other side of trades
- By selling order flow
Retail Broker Business Risks
Like any large business, growth is a desired outcome. Let’s explore the predominant business-model risks retail brokers face.
Referring back to the 90/90/90 rule, 90% of clients lose 90% of their money after 90 days. Thus, roughly 90% of the retail broker’s revenue activity ceases as 90% of clients have 90% less capital from which to generate revenue.
Retail brokers spend a sizable amount of money marketing and advertising to bring in new clients to keep the revenue stream going. Typical venues include TV ads, affiliate marketing and utilizing trading educators.
Without activity, the broker is neither offsetting their operating costs of keeping an account open nor making a profit on it.
Some retail brokers charge inactivity or generic maintenance fees for simply having an account. This is more common on accounts that are designed to NOT have frequent trading activity and not have margin features enabled, such as employer 401k plans.
My previous employer used to foot this bill. However, in a cost-cutting measure a few years prior to my departure they decided, amongst other plan downgrades, to have the employees bear the annual Fidelity 401k plan fee of $40. Upon departure I immediately rolled the account to an institution that does not charge these plan fees.
The “Best Client” Example
Reflecting on the financial industry value chain and retail broker revenue streams, let’s identify the hypothetical “best client” for each entity.
- Exchange’s’ best client:
- Institutions that:
- seek to purchase and research historic market data to find strategies and trends to beat the market
- trade with the highest volume and largest size the most frequently
- that seek real-time market data subscriptions to facilitate active trading
- Institutions that:
- Investment bank’s best client:
- Retail brokers that:
- generate the most line-of-credit income
- generate the most liquidity. Liquidity is generated through trade activity. The more activity, the more liquidity.
- Retail brokers that:
- Retail broker’s best client:
- Training educators that encourage retail traders to:
- maximize leverage
- day trade
- use strategies that are consistently / systematically unprofitable such as technical analysis, signals, etc.
- shift from buy-and-hold and get active
- Training educators that encourage retail traders to:
- Trading educator’s best client:
- Retail brokers that:
- pay the most per referred retail trader account opened
- offer the greatest commission revenue split
- Retail traders that:
- believe and employ / don’t research the concepts and strategies they are taught
- don’t question or are unaware of conflicts of interest
- Retail brokers that:
- Retail trader’s best retail broker:
- Commission-free trades
- No account maintenance or inactivity fees
- Provides the best price execution / does not practice payment for order flow
Ban on IB Agreements
Remember those Introducing Broker (IB) agreements from earlier? Singapore banned them in 2010. In 2016 Belgium did the same.
What does this mean for trading educators? Beyond the fact they cannot be compensated by retail brokers in these countries, its signals a potential trend in the financial industry that needs to be hedged.
Retail brokers hire trading educators as a way to defer marketing and distribution costs and optimize client acquisition. A famous marketing quote by John Wanamaker goes: “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” By compensating trading educators after clients have been brought on, retail brokers only pay for the successful customer acquisitions.
Retail Brokers offer Trading Education
What if retail brokers want to cut out the middleman without spiking marketing and client acquisition costs?
To permanently lower client acquisition costs we need to stop having 90% of clients blow up their account in 90 days by providing trading education that at a minimum significantly delays account dissolution and at best produces successful traders.
In doing this retail brokers essentially forfeit the OTC Gain (taking the other side of losing client trades) revenue stream in return for converting their business model to a “coupon” business. That is, retail brokers train traders to maximize other revenue streams (commissions, spreads, financing through leverage, payment for order flow, etc.) while keeping their accounts funded.
Among the option trader community there’s a familiar retail broker that does this: tastyworks.
tastyworks is a retail broker that performs and gives away quantitative research on options trading. This research is used to pitch active management, frequent and continuous trading and suggests implementing strategies such as SPY naked short puts and SPY vertical put spreads – strategies that have been independently confirmed to be consistently profitable (albeit less profitable than buy and hold) over the long term.
They want you to be successful, or to at least not go broke, so you can keep trading and continue to generate revenue.
The Retail Broker Business Impact of Buy and Hold
The buy-and-hold strategy is the most profitable and least expensive strategy to implement for retail traders. It is also the strategy most harmful to retail brokers’ business model. Let’s see why.
Most mainstream retail brokers don’t charge a commission to trade the buy-and-hold ETFs so the commission revenue is gone.
Buy-and-hold retail traders will buy or sell, depending on whether they’re in accumulation or decumalation mode, let’s say twice a month.
The spread on broad-market ETF products is typically a penny wide. The best case for the broker is they make the full penny twice a month per client.
Buy-and-hold investors typically don’t buy and hold on margin as there are less expensive vehicles to obtain leverage.
Financing will be limited to retail traders using margin as a cash management tool. That is, short term lending / HELOC alternative.
Institutional traders don’t short the S&P 500 as a long-term strategy; they will not be trading against you on your long broad-market positions.
Payment for Order Flow (PFOF)
With each client trading twice a month on the broad-market indexes, HFTs will derive limited value / ability to pay retail brokers for order flow due to minuscule transaction volume and exceptionally narrow product diversity.
The long-term buy and hold strategy is for going long. Retail traders will not be paying fees to retail brokers to borrow shares to open short positions.
While the data has suggested that some option strategies are indeed profitable over the long term, the data has also suggested that buy-and-hold indexing usually outperforms any basic options strategy with regard to both risk-adjusted and total return.
Curve fitting activities can identify options trading strategies that outperformed over a given period of time. However, curve fitting is an exercise in applied data mining and the best curve fitting strategies still underperform when taxes are taken into consideration.
The buy-and-hold strategy is harmful to the business model of retail brokers.
Retail brokers and several other entities in the financial industry have a strong incentive to promote continuously trading the most volume and largest size.