I had written this post a while back
This is how brokers in the US make money even without charging brokerage fees. Now that the interest rates in the US has picked up, the float income would have gone up significantly as well.
Float Income
Idle balances lying in a trading account earns interest income for a brokerage firm. In India, due to quarterly settlement rules, brokerage firms are required to send back any unused balance back to the client’s bank account. This rule was brought in thanks to a handful of bad apples misusing client funds. This also hurts brokerage revenues indirectly. Clients having money in their trading accounts have a much higher chance of trading than when in the bank account. If you were to compare this to US brokerage firms, most have internal rules set saying that they will not send back any money to the client’s bank without a fresh KYC if there was inactivity for a quarter, the exact opposite to our quarterly settlement rule. What this has meant is that US brokerage firms earn billions of dollars on idle client float. When I speak to our US counterparts about the quarterly settlements, they are shocked to hear that such a rule exists in India and question how brokerage firms manage to survive.
Payment for order flow
In India, all orders placed on a broker’s trading platform are sent to the exchanges in real-time for matching and fulfillment. Exchanges here earn by charging transaction fees on such orders. Contrary to this, in the US, exchanges’ main source of income is from selling data feed. So, to generate more transactions and better quality data, they offer rebates to brokerage firms to attract order flow. Typically exchanges have a maker-taker model, they pay rebates for providing liquidity (limit orders) and charge for taking away (market orders). For example Nasdaq will pay you 20 mils ($0.002) per share to post and charge 30 mils ($0.003) per share to remove liquidity. Brokerage firms this way have another source of revenue.
The crazy bit is that the order flow isn’t required to be sent to the exchanges at all. This can be sent to high-frequency trading firms or matched internally. These HFT firms, in turn, pay the brokerage firm rebate for all orders sent to them instead of the exchange, typically around 10 to 20 mils ($0.001 to $0.002 per share). This is not legal in India. The SEC (Securities and Exchange Commission, US capital markets regulator) mandates non-exchange matched trades to be executed at least at the National Best Bid and Best offer (NBBO) at that point, so client trades aren’t compromised. But HFT firms can make money by market-making with this order flow even within this tight range. For a retail client, this makes no difference at all if orders are matched at an exchange or sent to an HFT. According to my friends in the industry, Robinhood’s largest source of revenue is payment from selling order flows. The company is valued at $5 billion.
Securities Lending
The structure of our depository system, like our payments system, is a newer and advanced system as compared to the US. This is mainly because India didn’t have a legacy when we went online in the 1990s. We have depositories like NSDL and CDSL where we hold Demat accounts that remain unaffected even if a brokerage firm goes into trouble. In the US all securities are essentially held in book or street name with the respective brokers, what they call a “books and records system”. This means the securities are all held by brokers. This also gives an opportunity for the brokerage firm in the US to be able to lend these securities to people looking to short stocks or borrow for various trading strategies and earn an additional source of income (Unlike India, borrowing stocks to short is extremely popular in the US). The earning potential for these stocks held by the broker is typically based on the number of people wanting to short the stock. For example, early this year when Marijuana stocks were moving wildly, there were periods of time where one could earn as much as 100% or more annualized returns just by lending these stocks. Regulations in the US does mandate the brokerages to share some of the lending fees with the person who owns the stock, but the entire thing is quite opaque to the customer. Most never get to know how much was earned.
In India, brokers can’t lend securities as they sit in the clients’ Demat accounts with the depositories. Also, with the new set of regulations that came out on the 1st of Oct 2019, even securities bought by a customer that are unpaid for, cannot be pledged.
India does have an SLB (Stock Lending and Borrowing) platform where clients can participate directly, and know the exact lending fees being earned. This platform sees very little activity today, but may grow over time.