All of the major brokerage firms — Charles Schwab, Interactive Brokers, TD Ameritrade and most recently Fidelity — dropped their commission fees to zero this month, which means these companies will no longer be charging clients a fee per transaction.
So, how will they make their money? The broker can sell to a wholesale market maker, like Citadel Securities or Virtu Financials. These market makers buy or sell a stock at publicly quoted prices and actually pay brokerage firms for routing a trade through them. This practice of buying brokerage firm’s orders is called payment for order flow.
The client gives the brokerage firm an ask price, or how much they’re willing to pay. But as a part of an order the broker is given a second price, or a “bid price.” This is the price that the broker will find in the market and actually execute the trade on. The difference in the price is called the spread. In a structure where the broker sells the order flow to a market maker, the bounty is split by the broker and the market maker.
Selling order flow has become more lucrative for brokers. The big four firms made $792 million in 2018 off of selling order flow, up from under $600 million in 2017. TD Ameritrade, which makes the most money off of selling order flow, netted about $458 million in 2018. Robinhood, the mobile trading platform, has grown its routing revenue by over 40% in just the last year. The big firms followed suit in cutting their fees to keep their clients from running to Robinhood, or other fee-less platforms.
This practice has drawn scrutiny from regulators globally because it creates an incentive for brokers to send orders to whoever pays the most, rather than the place that might get the best outcome for customers. It remains to be seen if regulators will crack down on it.
Valentina Caval is a producer at Yahoo Finance. Brian Cheung is a reporter at Yahoo Finance.