In recent years, commission-free trading has completely shaken up the brokerage world. Gone are the days when investors had to pay steep fees just to buy or sell stocks, bonds, or other securities. Thanks to apps like Robinhood and moves by industry giants such as Charles Schwab, trading for free has become the new norm. But that raises an important question: If brokers aren’t charging commissions, how are they making money?

In this article, we’ll break down how these commission-free brokers generate revenue while letting you trade without fees. Understanding their business model will give you better insight into how your trades are handled.

Old vs. New: The Traditional Brokerage Model vs. Commission-Free Trading

Not long ago, each time you made a trade, brokers would charge you anywhere from $5 to $50 per transaction, depending on the company. This fee-based model was a core part of how traditional brokers made their money.

But everything began to change in the mid-2010s when companies like Robinhood introduced commission-free trading, forcing traditional brokers to adapt to stay relevant. As a result, major firms like Schwab and Fidelity quickly dropped their trading fees too, making free trading the new standard.

While this shift has been great for retail investors, brokers still need to find other ways to turn a profit. Let’s explore the creative methods they’ve developed to make that happen.

How Commission-Free Brokers Really Make Money

Even without commissions, brokers have plenty of tricks up their sleeves to stay in the green. Here’s how they do it:

Payment for Order Flow (PFOF)

One of the most significant ways that commission-free brokers make money is through Payment for Order Flow (PFOF). Let’s break it down:

• When you place an order to buy or sell stock, instead of sending it directly to the stock exchange, your broker routes it through a third-party market maker.
• These market makers are big firms that specialize in buying and selling large amounts of securities.
• These firms pay the broker for sending your order their way. The payment might be tiny (often just fractions of a cent per share) but when you add up millions of trades, it becomes a substantial revenue stream.

Why do market makers pay brokers? It’s all about the spread…the difference between the bid (buy) price and the ask (sell) price. Retail traders are typically less focused on getting the absolute best price, which allows market makers to pocket small differences in price and still pay brokers for routing orders to them.

Interest on Cash Sitting in Your Account

Another sneaky way brokers make money is by using the cash sitting in your account between trades. When you have uninvested money, brokers often sweep it into interest bearing accounts or investments.

You might see a very low or even zero interest rate on this cash, but brokers are making interest on that money behind the scenes. The difference between what they earn and what they pay you is pure profit for them.

Securities Lending

If you own stocks in your brokerage account, your broker can lend those shares to other traders or institutions, usually for short selling. This practice, called securities lending, allows brokers to earn interest or fees while you continue to own the stock and receive any dividends.

This happens behind the scenes and is mostly invisible to retail investors, but it’s a reliable income stream for brokers.

Margin Lending

Many commission-free brokers offer margin accounts, which let investors borrow money to trade more than what they have in cash. In return, brokers charge interest on these loans.

This can be a huge revenue source for brokers because margin loans often come with high interest rates…sometimes 5% to 10% or more. For brokers, this means consistent income from customers who want to increase their buying power.

Premium Subscription Services

Some brokers also offer premium subscriptions as an additional revenue model. For example, Robinhood offers Robinhood Gold, a service that gives users perks like:

• Access to margin trading
• Larger instant deposits
• Professional research reports

This model gives brokers a steady stream of monthly or yearly income from users who want extra features beyond the basics.

Affiliate Marketing and Rebates

Lastly, some brokers generate revenue through affiliate marketing and rebate deals. Here’s how:

• Brokers might partner with financial institutions to recommend specific products (like ETFs or mutual funds) and earn a referral fee if you invest in them.
• They may also receive rebates from exchanges or financial firms for sending trades their way.

These partnerships allow brokers to make additional money without charging customers directly.

The Debate Around Payment for Order Flow (PFOF)

While Payment for Order Flow (PFOF) is one of the biggest money-makers for brokers, it’s also been a source of controversy. Critics argue that it creates a conflict of interest because brokers might prioritize sending orders to the market makers who pay them the most, even if that means customers aren’t getting the best price on their trades.

For instance, in 2020 and 2021, Robinhood faced serious scrutiny over its PFOF practices. Regulators looked into whether the company properly disclosed how much it was making from PFOF and whether that practice resulted in worse execution prices for investors.

While PFOF remains legal in the U.S., it has been banned in some countries (like the U.K.), and the debate over its fairness is ongoing.

What Does This Mean for Everyday Investors?

For the average investor, commission-free trading has made the stock market more accessible and affordable than ever before. Without fees, people are more willing to make trades, even with smaller amounts of money.

But it’s important to remember that brokers are still making money in other ways. You’re not paying a fee for trades, but your broker might be making money behind the scenes through PFOF, interest on your cash, or lending your securities.

This doesn’t mean commission-free trading is bad. It just means that it’s a good idea to stay informed and know how your broker operates.

What’s Next for Commission-Free Brokers?

As commission-free trading continues to evolve, a few key trends are worth watching:
– More transparency: As scrutiny around PFOF and other practices increases, brokers may need to be more upfront about how they make money.
– New technologies: Blockchain and decentralized finance (DeFi) could disrupt the traditional brokerage model, allowing for peer-to-peer trading without middlemen.
– Increased competition: As the market continues to grow, brokers may offer even more tools and features to attract new customers.

Final Thoughts

Commission-free trading has opened the doors for millions of people to invest without worrying about hefty fees. However, it’s important to remember that brokers aren’t running charities. Whether through PFOF, interest on cash, or securities lending, they’ve found creative ways to stay profitable.

As an investor, understanding how your broker makes money is key to making informed decisions. The commission-free model is here to stay, but it’s always a good idea to keep an eye on how it works and how it might impact your trades.