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How Zero-Commission Trading Platforms Make Money?

Updated: Apr 18

In the modern age of financial technology, the rise of free trading platforms has revolutionized the stock trading landscape. Gone are the days of paying hefty fees for every buy or sell transaction. Instead, a plethora of platforms now offer commission-free trades. This naturally begs the question: How do these platforms make money? Understanding their revenue streams is crucial for investors to make informed decisions.

Revenue Streams

  • Payment for Order Flow (PFOF): Payment for Order Flow is a compensation a trading platform receives for directing its users' trade orders to specific market makers for execution. Example: Imagine a trader places an order to buy 100 shares of Company XYZ. The trading platform sends this order to a market maker, which fills the order. In return for sending the order their way, the market maker pays a small fee to the trading platform. This fee, although minuscule on a per-order basis, adds up quickly given the volume of trades processed daily.

  • Interest on Cash Balances: Just like traditional banks, many trading platforms earn interest on the uninvested cash that users leave in their accounts. Example: A user might have $10,000 in their trading account but only $5,000 invested in stocks, leaving $5,000 in cash. The platform can use this cash to lend out (in various capacities) and earn interest, sharing a portion with the user and keeping the rest as revenue.

  • Margin Interest: Many trading platforms offer margin accounts, which allow users to borrow money to invest. The platforms charge interest on these borrowed funds. Example: If a trader borrows $20,000 to purchase stocks, the platform might charge a yearly interest rate of 7% on this borrowed amount. Over a year, this equates to $1,400 in interest that the platform earns.

  • Premium Subscription Services: Some platforms offer premium services for a monthly or yearly fee. These might include research reports, real-time data, enhanced trading tools, or even financial planning services. Example: A trading platform might offer a “Gold” membership for $10/month, providing members with enhanced data analytics tools and priority customer support.

  • Lending Securities (for Short Selling): When traders want to short sell a stock, they need to borrow it first. Trading platforms can lend out shares from their users' accounts (with user agreement) and earn a fee in the process. Example: A trader wants to short 50 shares of Company ABC. The platform finds these shares in another user's account and lends them out. For this service, the platform earns a lending fee.

  • Ancillary Services: Platforms may offer additional services like robo-advisory, credit cards, checking accounts, or even crypto trading, where they earn fees or spreads. Example: A user decides to use the platform’s robo-advisory service. They are charged a 0.25% management fee annually on their invested assets.

  • Embedded Fees within Spread: The spread is the difference between the buying price (bid) and the selling price (ask) of a security. Some platforms may widen this spread slightly, which allows them to take a small cut from each transaction. Example: Suppose the real difference (spread) between the bid and ask price of a stock is $0.05. The platform might display a spread of $0.06 to its users. This extra $0.01 goes to the platform, which over millions of trades can accumulate into substantial revenue.

  • Foreign Exchange Fees: When users trade international stocks or assets, platforms might charge a markup on the foreign exchange rate, which can be another source of income. Example: If the current USD to EUR exchange rate is 1:0.85, the platform might offer a rate of 1:0.84 to users, keeping the difference as profit.

  • Data Monetization: Platforms can aggregate non-personal trading data and sell it to third parties interested in market trends and behaviors. Example: Market research firms or hedge funds might be interested in purchasing data to understand market trends, the popularity of certain stocks, and more.

Concerns and Considerations for Investors:

  • Transparency: Investors should be wary of platforms that aren't transparent about their revenue streams. Hidden fees or lack of clarity can be a red flag.

  • Order Execution: PFOF has been criticized for potential conflicts of interest. If a platform prioritizes payments over best execution, it might result in investors getting less favorable trade prices.

  • Regulation: Regulatory bodies, especially in the US, are scrutinizing free trading platforms and their revenue streams. It’s crucial to ensure you're using a platform that complies with all regulatory standards.

While “free” trading platforms have democratized access to the stock market, it's essential to remember that these businesses are not charitable entities. They earn money, often in ways that aren’t immediately obvious to users. As with all financial services, due diligence and understanding of the underlying mechanics are crucial for every investor.

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