The broad basics of trading financial securities like stocks is easy: One entity sells, and the other one buys. But how do those two come together to make a deal? Often, they need a matchmaker. And that’s where brokerage firms come in.
What is a brokerage? It’s a financial company that acts as a facilitator to make trades happen. They connect buyers and sellers to facilitate the trading of financial securities such as stocks, bonds, options, and other investments.
Some brokerage companies offer additional services like investment advice and research reports. Others are “discount” brokerages with more bare-bones services, but they offer lower costs for customers who want just trade facilitation and not much else.
Here’s how the business of trade matchmaking works.
What does a brokerage firm do?
The core function of a brokerage firm is to serve as an access provider to trading venues. Trading venues ( or “exchanges”, like the NYSE, NASDAQ, ASE etc) match buyers with sellers of securities.
When a person or organization wants to buy or sell a security, they place an order via their broker. They do this either through an online trading platform—generally the core option for clients of discount brokers, though some full-service firms also offer online platforms— or by speaking directly with their broker or a representative.
Brokers may route trades to a venue best suited for a particular trade. Some trades could be executed on a public exchange (like NYSE, NASDAQ or the ASE) and others may be routed to an Over-The-Counter (or OTC) venue. It’s then the broker’s job to find the most suitable venue for that trade. If their client wants to sell a stock, for example, they look where that security is listed or if such a trade requires to be executed OTC. The broker’s ultimate goal is to facilitate the trade for their client at the best possible price.
How do brokers work?
How exactly a match is made depends on the security in question. Generally, though, trading brokers scour market data to figure out the current market price and take into account details like the trading volume of that security.
Brokerages often leverage technology like proprietary algorithms and specialized trading systems to help them find a good match—something that happens automatically with online brokerages. Full-service brokerages also often tap their personal contacts within the industry.
It’s easier to find a so-called counterparty to execute a trade in certain cases compared to others. For example, a broker would likely easily find a trade for a highly liquid security like a stock that trades on one of the major exchanges.
But trades of more unique or specialized securities may take longer, or may even ultimately not be executed—such as securities like certain kinds of bonds or private-equity investments that trade on smaller markets with less volume, as well as more complex instruments like some types of derivatives.
And a broker with a client who’s willing to trade only at a specific price or delivery date may have a tougher time finding a counterparty who’s willing to meet those requirements.
The 3 types of brokerage firms
These firms offer a breadth of investment services including financial planning and portfolio management, and they generally hire teams of financial advisors who work directly with clients to personalize investment strategies based on their goals. These firms, which include Fidelity, Edward Jones, and Morgan Stanley, typically charge higher rates in exchange for more comprehensive service.
These are often online-only brokerages, and they may let clients buy and sell securities themselves. They generally don’t offer investment or portfolio advice, and their fees are often lower than full-service brokerages. Examples include E-Trade, Webull, and Public.
This is something of a combination of the first two categories: Robo-advisors are online investment platforms that do provide investment advice and manage portfolios, but they do it by leveraging algorithms to customize for a client’s needs. Fees tend to be higher than discount brokers but lower than full-service for these firms, which include Betterment, Ellevest, and WealthFront.
How do brokerages make money, and how do stockbrokers make money?
Brokerage firms and the individual stockbrokers they employ make money in a few ways. They have to balance the need for profit with the client’s desired trade parameters, current market conditions, the available counterparties, and more.
How do brokerage firms make money?
In some cases, when a broker executes a trade for a client they may earn a commission based on the amount of the transaction. This may be a fixed per-trade fee, or calculated as a percentage of transaction value.
Some brokerages charge several different types of service fees, including for account maintenance, transfers, or trades of certain investment products.
Indirect revenue sources
Brokerages may earn revenue from indirect sources like interest on client funds, lending securities, and other activities. Similarly, brokerages may earn from routing a large volume of their clients’ trades to a particular venue, called payment for order flow.
How do brokers make money?
In addition to the above, the individual stockbrokers may earn commissions and other forms of compensation like bonuses based on their sales performance or signing on new clients. Contracts and salaries can differ based on the brokerage.
Questions to consider for a brokerage account
● Do I want someone to manage my portfolio for me?
● If I need to pull money out, do they offer instant payouts or will I be waiting a while?
● What fees and commissions do they charge?
● Which investment options do they offer?
● What trading technologies and other tools do they leverage?
● What level of customer support do I need?