Have you ever wondered how ‘commission free’ brokers make money, and not just some, but a lot?
September 26, 2021
Do you ever trade via a retail broker? If you do, you are most likely being taken advantage of in more ways than one.
Have you ever wondered how ‘commission free’ brokers make money, and not just some, but a lot? In eToro’s case, £440 million in 2020, to be precise.
Brokers have many ways of taking your money from you. They claim to be commission free, but what does this really mean?
To keep the FCA happy, they can indeed claim that they charge no commission on trades. What they haven’t told you is that commission is an out-of-date charging mechanism used by old fashioned stockbrokers.
Back in the day, they would take your order to buy or sell a stock, and charge a ‘brokerage fee’ per trade on top. This would be their commission. That still happens if your broker wears a pinstripe suit, but in the modern world, it’s done very differently, only they don’t want you to know about it.
If you have an account with eToro for example, you will place your order, and it will trade on the buy or sell price they give you. Simple. They charge no brokerage/commission, so how are they making money?
Have you ever wondered who is actually making you the buy and sell price and what happens with the other side of your trade?
If a FTSE future is currently trading at a value of 6100, you might get a price of 6095/6105. This means that if you want to buy it, you have to pay 6105. In simple terms, the broker has sold you something worth 6100 at 6105. Technically, there was no commission. Prices are widest for retail traders ie. you, which means they can make even more money.
The same future on ICE (Intercontinental Exchange) might be 6099/6101 which is where professional, institutional traders will be placing the same trades. At this point the broker can get out of the trade instantly with them for a profit.
It’s incredibly advanced and computers can now trade on their own, selling you something at 6105 and then buying it back immediately at 6101.
So, when you are told they don’t charge commission, it’s because they don’t need to; any time you trade anything at all, the broker is making money.
They can also make the price wider if they like. Would you notice? The more illiquid the asset, the wider the price. If you have an account with one broker, they know you won’t get a price off anyone else, so they can do what they like.
On institutional exchange traded products, a fund would go to an interdealer broker, who would in turn call 5 different Market Makers (liquidity providers who give the tightest bid/offer spread) and report back with the best buy price of the 5 and the best sell price of the 5, thus ensuring the best overall market price for their client.
In retail trading, the ‘trader’ goes to one broker, and trades regardless of the price. If you place very few trades, this might not seem like a lot, but if the broker is holding client assets of $8.4 billion like eToro do, this adds up very quickly. If you take a little off a lot of people, nobody seems to mind and it’s all good fun; this is how betting companies stay in existence.
Is it any wonder that brokers names like ICM, Scope Markets and etoro are starting to appear as premier league sponsors?
This isn’t the only way they are taking your money.
Have you ever heard of A booking and B booking?
In the regulated institutional futures contract and stock markets, all transactions are sent to an exchange that confronts buyers' and sellers' orders by sorting them according to price and time of arrival leading to overall best execution, but, with retail brokers, they can make any spread they like. They can also choose to fill an order and keep the other side if that particular client always loses money.
This is simply when a broker acts as an intermediary that sends their clients' trading orders directly to liquidity providers or multilateral trading facilities (MTFs). These brokers make money by increasing the spread and then offloading the trades at a better price.
They are making a buy/sell price wider than the one on the exchange and keeping the difference.
However, as we have explained, they will not describe this as ‘commission’, therefore they are commission free brokers giving you the impression you are trading for free when the truth is far from it.
Larger brokers and liquidity providers are also likely to use a B Book as this keeps their clients' orders internal. What happens is they take the other side of their clients' trades, which means that the brokers' profits are often equal to their clients' losses.
Brokerage firms are able to manage the risks associated with the holding of a B Book by using certain risk management strategies such as, internal hedging through the matching of opposite orders submitted by other clients, spread variations, etc. As the majority of retail traders lose money (around 75%), the use of a B Book is very profitable for brokers.
It is obvious that this model generates conflicts of interest between brokers and their clients. More experienced traders are often worried about being subject to the underhanded tactics of some brokers who seek to always be profitable. That's why the larger market maker brokers use a hybrid model that involves placing trades in an A Book or in a B Book based on traders' profiles.
The popularity of the hybrid model is understandable, as it allows brokers to increase their profitability as well as their credibility. It also enables brokers to earn money off of profitable traders by taking money out of the spread and dispatching their trading orders to liquidity providers.
To efficiently identify profitable traders, as well as unprofitable ones, brokers have software that analyses their clients' orders. They can filter traders according to the size of their deposit (the percentage of winning traders increases significantly for deposits over $10,000), the leverage used, the risk taken on each trade, the use or non-use of protective stops, etc.
In essence, they can ascertain whether the trader knows what they are doing, or is a novice likely to lose their money.
TPP currently has no clients with less the $10,000. The problem with small accounts is investors seem to treat them more like a betting account than an investment.
To conclude I will use a recent statement given by Shalom Berkovitz, CFO and Deputy CEO of eToro (a company that claims not to charge commission).
“3.1 million new registered users joined the eToro platform this quarter, a 214% increase compared to the same period last year. This increase in users and an increase in trading activity resulted in total commissions of $347 million in the first quarter of 2021, up 141% from the first quarter of 2020.
Yoni Assia, Co-founder, also added this: “eToro’s mission is to empower people to grow their knowledge and wealth and we see our platform as a bridge between the old world of investing and the new".
On top of the commissions that weren’t commissions, net trading income for eToro in this quarter was $269 million. This is the amount made from activities such as B booking. They are taking the opposing side of trades made by the very same clients they are trying to empower, and who they know will almost certainly lose money.
We have always said that if this really is their mission statement then they are doing something incredibly wrong. The first thing you see when you go to their homepage is that 67% of their users lose money. Surprisingly this is actually one of the best.
In contrast to this, as of the moment of writing this, we can report that 0% of The Portfolio Platform users have lost money to date. Right now, 100% of TPP users are in profit (accurate as of 25/08/2021). This is because every one of our traders is a professional with years of experience.
We at The Portfolio Platform have one goal: to make investors money. We have devised the best possible method to do this. We have recruited the best possible traders from around the world, we showcase them on our website, and we let investors autotrade them (automated trading via our innovative software). There is no management fee, no performance fee and NO COMMISSION (we are not a broker).
What we do charge, is a subscription. It’s simple. We have strategies from as little as £60/month. You can build a portfolio of 3 traders for less than £200/month (what is a hedge fund if it isn’t a portfolio of traders?).
We don’t allow traders on the platform who can’t prove a track record good enough of making the 30 spaces available. Only the best will be showcased. We have done the hard work and recruited only those who we can trust to perform so our users can feel safe.
Look at our client testimonials which will confirm just how happy our users are and how TPP is changing the investment world.
If you wish to book a call and speak to a member of the strategy selection committee, please click here.
“TPP might just be about to revolutionise investment for the retail market.”
- London Stock Exchange 2020