How do commission free brokers make money?

How do commission free brokers make money? There are many ways but most commission free brokers don’t make profits and rely on funding or use these accounts as advertisements for more profitable activities such as CFD trading.

For any successful business to work, they need to create cash flow into the company to help pay costs and towards R&D to develop the business and evolve to become more profitable.

More established brokers such as Hargreaves Lansdown, Interactive Brokers, and AJ Bell have this nailed down and are well-performing brokerages. New to the scheme we have commission-free brokerages to shack up the game.

But being commission-free means potentially less profit or even income, especially when compared to established brokers who can charge up to £12 a trade.

In this article, it’ll show some examples of how investment platforms like Hargreaves Lansdown and AJ Bell make money and compare them to the latest commission-free brokers such as Trading212, InvestEngine and Freetrade.

How Do Commission-Free Brokers Make Money?

While commission-free brokers are relatively new, most of them don’t make money or to the point don’t make profits.

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While commission-free sounds enticing it does not mean that its free. While you don’t pay a direct fee on trades there are ways of these types of companies profiting from your trades/investments.

While brokers such as Trading212 and InvestEngine offer commission free investing brokerage Freetrade operate under a Freemium model.

This is where they offer a basic service for free and then upsell other products that customers are willing to pay for.

Another example is InvestEngine where they offer a free DIY account where you are able to pick and choose your ETF investments or have a tailored portfolio but comes with a fee.

While commission free investing can be attractive to investors, it means these brokerages have to make money in other ways, ones which we shall go into detail in a second.

In 2020 Freetrade had auditors highlight that they would need to raise additional funding during the year in order to meet their cash requirements. As a result Freetrade has done multiple investment rounds with their latest round raising £30 million from existing and new investors.

Charge For Certain Account Types

Generally commission free brokers are giving their customers free access to the General Invest Account (GIA) but are offering more catered accounts such as a ISA or SIPP with a small fee.

While GIA accounts are simple taxable accounts the ISA has special properties, being a tax advantaged account. Though the ISA has special properties they are extremely common type of account to offer and realistically it doesn’t seem to be sustainable to charge for such an account.

Freetrade’s falling grace over 2019-2020 for their ISA and its fee was that Trading212 was not open to new accounts and the next best place for many investors to start investing through an ISA was with Freetrade. But in the mean time there has been an increasing amount of new to the scene commission free brokerages.

An alternative example of offering free account and benefiting comes from Trading212. Trading212 was originally a CFD trading platform before offering commission free investment accounts. Despite large growth Trading212 did not make profit from offering investment accounts.

However, it seems that by offering free trading real stock accounts, it acted as advertisement for their CFD platform. During that time Trading212’s CFD business revenue grew from £2 million in 2019 to £54.3 million in 2020.

FX Fees

Most brokers, not just established ones, continue to charge Foreign Exchange (FX) fees. The most commonly traded stocks are based in the US, where they offer some of the highest growth, and is priced in Dollars.

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When converting your GBP or EUR to USD brokers can charge you a FX fee, so in some ways this is just another type of trading commission for buying/selling foreign stocks.

The only way to avoid paying this fee is to stick with stocks from your own home market.

Interest Rates

Just like you, with a savings accounts you maybe given an interest rate, like a thank you for giving them your money.

With brokerages its often some money isn’t invested and just sits there as cash. Your broker is unlikely to be paying you the interest gained on any cash holdings but is more than likely to scoop it up for themselves.

With interest rates currently still rather low these brokerages are most probably not earning a substantial sum but with rising interest rates, you’ll definitely be able to see it reflected in revenue reports.

An example, with the current low interest rates Hargreaves Lansdown still managed to make £53m in a single year from interest on cash holdings.

Securities Lending

Securities Lending is a very common practice among brokers where they loan out shares to other investors or firms and in return a fee is paid.

Typically these shares are lent out to short sellers who borrow the stock and then push down the price. The borrower hopes to profit by selling the security and buying it back later at a lower price.

This can be a easy revenue stream for brokerages to create and is common with Freetrade recently joining a growing list of brokerages doing this service.

Some brokers pay investors for lending out their shares to short sellers but there are not many brokers who do this.

Managed Services

As mentioned earlier InvestEngine not only offers a fee free DIY portfolio but also a managed portfolio account. For the managed portfolio account they charge 0.25%. Currently they claim that 2/3rds of their clients assets are managed.

By offering a free DIY account they aim to up-sell them to their premium service, much like Freetrade with their Basic account being free and upselling to their Standard or Plus account.

Margin Lending

While margin lending is not seen on any UK commission free platforms, its common practice in the US.

According to InvestEngine’s crowdfunding, they plan to introduce this.

Margin lending is where investors borrow from the brokerage to invest in shares and other financial products and use existing investments as a security against the loaned money. When margin lending, the borrower pays interest on the money and the brokerage gains a revenue stream.

What About Spread?

It’s a common belief to many new investors that platforms widen the spread between the buy and sell price of stocks to profit from it.

Contrary to this FCA regulated brokers are obliged by law to create the best result for their clients with price and costs being the key factors which must be considered.

The real affects on spread, getting narrower or wider, depends of the currency involved, the time of day a trade is made, economic conditions and liquidity of the stock. The liquidity of a stock is the main factor for the spread difference.

Research by Brokerchooser found that spreads have very little difference among all brokers and usually the best execution prices, which are required by regulators, are very close to each other.

How Do Established Brokers Make Money?

Some of the established brokers in the UK are publicly traded companies, such as Hargreaves Lansdown, and many of these give an overview of their revenue breakdown in their annual reports.

Viewing their annual reports we are able to see exactly how the business creates its revenue.

With these established brokers they are able to offer many services for customers allowing more income streams. These services can include Fund Management, Advisers and other services like Wealth Management.

Hargreaves Lansdown

One of the major established brokers in the UK is Hargreaves Lansdown. With Hargreaves Lansdown being a publicly traded company we can easily take a look into how they make their money.

Taken from Hargreaves Lansdown’s financial statement for 2021, page 145. It can take a bit of scrolling through financial statements to find relevant information as realistically a lot of the financial statements are fluff.

Hargreaves Lansdown Revenue
Hargreaves Lansdown Revenue

Breaking down the Hargreaves Lansdown report we can see that the majority of their revenue comes from their platform fees and trading fees. HL charges 0.45% annual management charge for holding shares, ETFs, investment trusts, and bonds within the ISA (capped at £45 p.a.) and SIPP (capped at £200 p.a.) and this source of income (platform fees) generated £263.7 million in revenue. This revenue stream accounts for 42% of their overall income.

The second highest revenue stream came from trading fees, totalling £231.6 million, this comes from HL charging £11.95 per stock trade, while funds are free to trade.

Interactive Investors

While Interactive Investors is not a publicly traded company and so doesn’t have to release annual reports the company published an accounts report for the year 2020.

Interactive Investors Revenue
Interactive Investors Revenue

As you can see that Interactive Investors 51% of their revenue came from transaction fees, where they charge £5.99 per trade.

AJ Bell

AJ Bell Revenue
AJ Bell Revenue

AJ Bell and Interactive Investors are both of similar revenue size and comparing these 3 established brokerages we can see that they earn the majority of their money through platform charges and trading transaction fees.

Are Commission Free Brokers Safe To Invest With?

In most cases commission free brokers are safe to invest with but there are some ways to make sure that your money is safe and insured.

First check if a brokerage is authorised and regulated by the FCA. To do this you can go to the FCA website and search the companies name.

If a brokerage is regulated and authorised by the FCA you know that your money is ringfenced and segregated from the platforms own business and is then protected by the Financial Services Compensation Scheme (FSCS).

Being FCA regulated and having FSCS protection is normally something brokers want to show off so will make it obvious that they will do their best to protect your money, though it is still worth while double checking via the FCA website.

Drawbacks Of Commission Free Brokers

There are some common drawbacks amongst commission free brokers, though these may not apply to all. Over time these can change as a brokerage grows, matures or secures new/more funding.

It is common for brokerages to apply for new funding so they can develop new features or to steer the company in a new direction.

  • A small range of investments
  • Fewer account types to offer
  • A small or watered down customer service
  • Encourages to frequently trade
  • Pooled orders
  • No automatic investing

How Do Commission Free brokers make money?

Hopefully by now you have understood how commission free brokers make their money, especially compared to the more established brokerages.

These companies over the next couple of years may evolve as they secure more funding or clients and grow. As they change they may introduce new features, account types or even fees.

To make sure that your money is growing at the best possible rate it is important to make sure the account type suits your goal and that you have access to the features you require.

How do commission free brokers make money? There are many ways but most commission free brokers don’t make profits and rely on funding or use these accounts as advertisements for more profitable activities such as CFD trading.

If you are looking for a brokerage then check out our article on choosing a brokerage.

Choosing a Brokerage

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