Meet Eddy. He works hard all day. He saves some extra bucks for his retirement by investing in the stock market. For this, he banks upon the services of a brokerage firm. But what exactly are brokerage firms and what do they do?
If the present economy reflected a “perfect market” where all factors had perfect knowledge and the capacity to quickly and correctly act on it, there wouldn’t exist a need for brokerage firms. However, in reality, there is irregular knowledge and transparency, resulting in unawareness about the buyers’ and sellers’ identity, offering, and price. To bridge this gap, a brokerage firm behaves like a crafty middleman who provides grounds for a transaction between buyers and sellers. These companies are committed to bringing together buyers and sellers to match the perfect trade at the best price possible, and thus generate a commission for such arrangements. They charge commissions or fees once the transaction has been successfully completed.
The birth of brokerage firms
The United States welcomed the first stock exchange in 1790 in its financial capital of New York City. Initially, stock exchanges were a mode of facilitating transactions between banks and corporate. The companies raised hassle-free finance by selling stocks without the need to obtain loans. But by the 1820s, the market opened its arms to inter-company trading, with individuals also investing in stocks. This led to the birth of stockbrokers and brokerage firms as a medium to professional mediation of the transactions. Today, the law necessitates that every single stock exchange is directed with the assistance of an enrolled brokerage firm or independent stockbroker. It plays the role of a depository participant for ensuring vital steps like opening a Demat (dematerialized) account for listing securities electronically and for communication between investor and depository institution (holder of securities). It then places an order, executes it, and initiates settlement (transfer of securities).
How do they operate?
In the financial markets, several different types of brokerage firms operate. Starting from the most expensive type, the three major kinds are:
- Full-service brokerage firms:
A full-service brokerage firm works by assigning a professional financial advisor who directs investment decisions through suggestions, support, research, reason, retirement schemes, and tax tips. They provide full readymade expertise for those who might not be regularly updated with complex market issues and efficiently facilitate trade, manage portfolios, and are responsible for financial planning and wealth management ventures. These high touch services do come at an exorbitant price, making them the most expensive of its kind.
- Discount brokerage firms:
Discount brokers are the kind that allows DIY or self-directed investors to carry out their own trading decisions at relatively low or flat fees for trade. Put simply they facilitate exchange minus financial advice and market analysis and are responsible only for executing the deal. They don’t incur costs of sealing deals with high net worth offerings, neither have high overhead due to online operations, making them a relatively cheaper alternative.
In a world going digital, brokerage translates into an automated investment advisory platform with minimum human intervention. Robo-advisors are known to manage exchanges through devising algorithms, that too at a very low cost. It simply combines information from clients and merges them with their future goals, and offers appropriate education, security, service, and planning.
Independent versus Captive Brokerage
Independent brokerages do not hold affiliation to any mutual fund company and are thus in a better position to suggest and sell products that are most likely to serve the best interests of the clients. They hold to the fiduciary standard, which states their services are dedicated to the client’s betterment and not just high commission for themselves.
Captive Brokerages work in affiliation to specific mutual funds or insurance companies, allowing them to only sell their products. These brokers vividly propagate the products owned by these companies.
What do they do?
Brokerage Firms and the Trade of Stocks
Traditionally, the majority of brokerage firms earn through broking stock trades. They legally represent their clients on the floor of the stock exchange and notify clients about buying, selling, quantity, and pricing of stocks. After execution of the deal, the brokerage firms earn a percentage of transaction profit in the form of fees, and in case the client loses money, so does the firm.
Often these firms engage in such transactions as their principal by sending a broker to the exchange floor to trade for their own firm, just like it does for a client.
Brokerage firms and margin accounts
Brokerage firms allow clients to operate through margin accounts, by making them purchase securities using funds lent to them. The loan extended is secured by collateral in the form of cash or assets. This is attractive because it comes with a periodic interest rate.
Brokerage Firms as Investment Advisors
Brokerage firms also play the role of financial and investment management advisors. They examine the client’s financial health, immediate and long-term needs, following which it devises an action plan guiding him whether to buy or sell stocks. They actively provide wealth and investment guidelines and ensure financial soundness in exchange for a fee.
Brokerage Firms as Client Representatives
Quite often the clients may authorize the firm to become his legal representative. By doing so, he leaves all decisions regarding stock transactions up to the firm. The firm then initiates the most profitable transactions for his clients, managing the complete accounts of the client. They may charge a fee or take a percentage of transaction profits.
How do “zero commission” brokerage firms earn?
The new and attractive “zero commission” brokerage firms do make money, but just minus one revenue item: commissions. It comes as a defense strategy to attract a huge client base. What comes as clear as a craft is that firms generate money by routing trade orders to market makers, who actually execute transactions and generate wealth from the spread between the bid and ask prices, or the value they can purchase the stock for and the cost at which they offer it to financial specialists. These spreads are normally pennies, so they bring in their cash from volume – and are happy to give brokers a cut of their benefits in return for order flow. These firms also rely heavily on other major revenue lines like stock loans, interests on credit balances, margin interests.
Interestingly, Charles Schwab, a leading brokerage firm in the US has $4.04 trillion in client assets and over 12.3 million active brokerage accounts.