How Do Zero-Commission Brokers Make Money Without Transaction Fees?

Traditional online brokers earn revenue through a variety of means, including transaction fees, cash deposits, and other services. However, many zero-commission brokers have revolutionized the industry by offering their services free of transaction fees. While these brokers seem to be giving away something that most brokers charge for, how do they still manage to make money? This article explores the different ways in which zero-commission brokers generate income.

Payment for Order Flow

The primary method by which zero-commission brokers make money is through payment for order flow (PFOF). This involves directing trades to market makers, who make money from the bid-ask spread, the difference between the price at which a market maker is willing to buy (bid) and the price at which it is willing to sell (ask).

How It Works

Here’s a breakdown of the process:

When a trader places an order through a zero-commission broker, the order is directed to one or more market makers. The market makers then execute the trade based on the best possible price. In return for directing these trades, the broker receives a small amount of the spread as a fee.

This model allows zero-commission brokers to offer trading services for free while still generating revenue from the spread.

Earnings from Investing Free Cash

Another way zero-commission brokers make money is by investing the free cash from traders' accounts. When traders deposit funds into their accounts, the broker can invest this money in a variety of securities or financial instruments. The returns earned on these investments are shared with the broker, providing an additional revenue stream.

Earnings from Other Services

Zero-commission brokers also generate revenue through other services, such as investment management advice. Many brokers offer a range of services beyond just executing trades, including financial planning, portfolio management, and educational resources. These services can be monetized through subscription fees, one-time fees, or performance-based fees.

Understanding Zero Brokerage Models

It’s important to understand that zero brokerage is a marketing gimmick. In reality, brokers operate under different models, and the terms "zero brokerage" can vary:

Zero brokerage on delivery trades only. This means that brokers earn money from derivative trading in stocks. Some brokers offer zero brokerage on intraday trades, but charge for delivery trades, or vice versa. They may make up for it through maintenance charges or demat charges.

For traders, the cost of using these platforms is often hidden in the form of PFOF and the spread, which can sometimes be larger than the transaction fees charged by traditional brokers.

Market makers and zero-commission brokers are willing to pay for volume because the volume translates into more trades and more spread income. However, from a trader’s perspective, this can result in lower trade quality in terms of price and speed.

Choosing the Right Broker

For traders, deciding whether to use a zero-commission broker or a traditional broker depends on individual needs and trading style. Zero-commission brokers are generally better suited for passive or swing traders who are not heavily involved in active and intraday trading. For more active traders, the cost of PFOF and lower trade quality might outweigh the benefits of zero transaction fees.

Professional platforms that offer premium services and higher-quality execution may be a better choice for traders who require a high level of trade quality and speed.

Traders should carefully evaluate their options, considering both the costs and benefits of different brokerage models, to determine the best fit for their needs.