Saving Retail Brokerages: New Revenue Streams
Buying or selling publicly traded securities no longer costs an arm and a leg. Technology has automated and streamlined capital markets, and stockbrokers have passed these cost savings to traders and investors. Commission-free brokers like Robinhood, Freetrade and Trading212 have captured the younger investor crowd with their sleek and affordable trading experiences. Fee compression is nothing new in the financial industry and while it did create lots of wealth for the Average Joe, retail brokers are seeing their main revenue stream dry up.
For almost a decade now, the retail investing/trading scene has been consolidating as smaller brokers find it commercially unviable to continue their operations. Increased competition from low-commission and FinTech brokers is also causing fees to dive further down. Furthermore, new regulatory frameworks that favour retail financial customers like the FCA’s Consumer Duty require firms to justify their exorbitant fees. ‘Plain-vanilla’ retail trading fees are only centimetres away from the floor and firms have been diversifying to various degrees of success. Before we dive into how retail brokers are desperately diversifying, let’s review their basic business model.
How does a typical retail broker make money?
A typical retail broker would allow someone like me to buy diversified Exchange Traded Funds (ETFs) on payday or YOLO my entire portfolio into Gamestop because of a Tweet. Today, these brokers probably make almost no money from a buy or sell order in commissions. Instead, they could charge a reasonable FX fee to allow their users to trade securities denominated in another currency.
Retail brokers would probably also charge you a monthly service or subscription fee. There are brokers like Freetrade that opt for a Freemium model and firms like Interactive Brokers that cater to sophisticated traders which could charge higher monthly service fees from their value-adding products such as Trading APIs, advanced research and market data. Also, if you opt to leave the investing decisions to the brokers or get their financial advice, they can also charge something like a management fee.
If a retail broker also caters to ‘ambitious clients’ that have higher risk tolerances, they can also make bank through the ‘spreads’ of these trading instruments. Traders could profit off the price movements of a stock, commodity or currency through derivatives called Contracts-For-Differences (CFDs) or Spread Bets. Some brokers could also offer other widely-traded derivatives like Options or Futures. Depending on their regulatory status, these brokers may be allowed to make those markets and profit from the spreads too. The brokers can set their own prices when buying or selling that specific instrument and profit from the difference between those prices, much like how market makers like Citadel are picking up pennies from market-making Apple or Tesla stock for example. Moreover, brokers can also lend money to traders via margin loans, allowing them to amplify their gains (and losses), earning a bit of interest income.
Other forms of interest income can come from ‘behind the scenes’ products as well. They could make some money by putting their customers’ funds in government bonds or money market funds. Additionally, they could also lend out some of the securities held by their customers (with their consent). Nowadays, because of the higher interest rate environment, brokers have been passing more of this interest income to their own customers, like how Trading212 offers a jaw-dropping 5.2% annual interest on uninvested GBP funds.
What is their growth strategy?
The current revenue streams mentioned above are quickly evaporating. Most commission-free brokerbarely make a penny from retail customers trading publicly listed securities. Although they can enjoy a steady, predictable revenue stream via those monthly service or platform fees, it pales in comparison to the amount of money they were making 20–30 years ago. Despite still making fat margins on derivatives, these super-risky traders are slowly becoming extinct. Retail investors are slowly becoming ‘lazier’ as we realise that we can rarely beat the market and the time spent on reading company results can be better spent elsewhere. The popularity of passive investing means that catering to retail day traders or stock pickers is a sunset industry. Even though high-risk day traders still exist (and are lurking on Reddit forums), brokers can no longer rely on Average Joes to support their businesses.
So what have they tried so far? One option would be to expand the profile of their target customers. Brokers can start finding more Average Joes in other geographies. Emerging markets like Southeast Asia, the Middle East and Africa are relatively untouched, but they are difficult places to enter because of complex (or the lack of proper) regulatory regimes. An example of an expanding CFD broker would be XTB, who is looking to get regulatory licences in Brazil and Indonesia. Besides geography, brokers can also target the non-retail crowd. Brokers could target commercial clients with their derivative products to help them hedge against market movements or work with trading teams of financial institutions, for example.
Besides selling the same things to different people, brokers can also offer new trading instruments to their existing client base. IG Group (a diversified retail broker that offers vanilla investments and CFDs), for example, have acquired a US broker, Tastytrade, in 2021 for this exact purpose, allowing their US clients to trade US stock options. Some of the larger retail brokers have also come to the conclusion that their client base would also be interested in trading Crypto. Oanda acquired Coinpass in 2023 and Robinhood acquired Bitstamp shortly after too.
Brokers can also try to move more of their customers’ financial activities onto their platforms by creating an ecosystem or a ‘superapp’. It can be highly profitable and sticky if retail brokers can convince their customers to put more of their money, receive payments and spend money from their broker accounts. Customers can enjoy a streamlined financial experience and brokers could unlock new revenue streams. Inspired by Etoro customers’ rapid adoption of the Etoro Money products, other brokers like Trading212 are also offering multi-currency wallets and spending cards for their customers too. As mentioned earlier, interest income is one of the main existing revenue streams of retail brokers. Having customers deposit more of their ‘uninvested cash’ because of the ease of having all of one’s financial services in one app would give this revenue stream a much needed boost too!
Lastly, a new revenue stream that’s gaining traction is securities lending. Retail brokers, with the consent of their retail customers, will loan out their securities to other financial institutions for a fee. Financial institutions may be interested in loaning securities to fulfil certain market making obligations or execute a short sale strategy (bet on prices of something going down). Securities lending is usually backed by high-quality, liquid collateral such as government bonds — so it is way safer than loaning a couple hundred dollars to a friend (who may not pay you back). Retail brokers would handle the entire process and give retail customers a cut, pocketing the rest.
Have they been successful?
These growth strategies were successful in getting more users and/or transaction volumes, but revenue performance in retail customer segments or CFDs have been a mixed bag. Through annual reports of publicly-listed brokers and some broker-banks (like Saxo), these firms reported increased activity in non-retail customer types, like institutions and commercial, and growth in other non-trading income streams. In particular, the stock prices of most of these firms bounced back because of high interest rates. Every annual report I’ve read has mentioned how firms welcomed the increased revenue from interest income (from uninvested customer cash and other investments). This may have bought them some time to see how their growth strategy will play out, but ultimately, I would expect more brokers to be swallowed up by larger brokers, or become part of an integrated financial ecosystem of a larger firm. International expansion is a slow, tedious process because of compliance requirements and there is a limit to how much money users will cough up to trade more exotic (or leveraged products). It seems like the only way out is to diversify and the least painful way could be to get swallowed up by bigger firms…
I hope this breakdown of the business models behind brokers have been useful and I’m interested to see what new, creative ways retail brokers will come up with to get customers to stay. Perhaps a fixed term loan to boost your portfolio like Belong? Or maybe something radical like allowing investors to get their stock dividends earlier for a price, who knows!
