How do brokerage firms make money: Yahoo U

Once a staple of the brokerage industry, commissions on stock trades are now a relic of the past.

Spurred by Robinhood's disruptive elimination of commissions entirely, the major brokerages — TD Ameritrade, E*Trade (MS), Charles Schwab (SCHW) — have followed suit in turning to payment for order flow as a key source of revenue.

How payments for order flow works

In a payment for order flow model, a brokerage processes orders from investors and passes them on to a wholesaler, like Citadel Securities or Virtu Americas. These market makers then execute the purchase or sale of a stock at publicly quoted prices, in turn paying brokerage firms for routing the trade through them.

The profit-sharing of this scheme is built into the bid-ask spread.

In a trade, a client gives the brokerage firm an ask price, or how much they’re willing to pay for a security. The price that the wholesaler is able to locate and execute on is called the bid spread.

If the wholesaler is able to purchase the stock at a lower price than the client asked for, the bid-ask spread serves as a bounty split by the brokerage and the wholesaler.

A wholesaler pockets some of that spread for its work in finding the better price, and the remainder is paid out to the brokerage for passing along the order to the wholesaler in the first place (hence, “payment for order flow”).

The brokerage can do a few things with this payment: It can pass along some of the savings to the investor (reflected as purchasing the stock at below ask price), or it can pocket the savings within the company.

Revenues from PFOF exploded in 2020

Data from Alphacution shows that revenues from payments for order flow almost tripled at the four major brokerages, from $892 million in 2019 to to $2.5 billion in 2020. Other brokerages, including Webull, Ally Invest, and Interactive Brokers accounted for another almost $300 million in payments.

At Robinhood in particular, payments for order flow increased ten-fold between 2019 and 2020, from $69 million to $687 million.

Among wholesalers, Alphacution further notes that 41.7% of payments to all brokerages for order flow in 2020 were paid by Citadel Securities.

The January boom in "meme stocks" like Gamestop (GME) and AMC Entertainment Holdings (AMC) suggests that surging interest in retail investing could further boost revenues made from payment for order flow.

Lawmakers and regulators have raised questions about the transparency of payments for order flow, leaving the door open to the possibility of reforming the existing regulatory structure.

Currently, the Securities and Exchange Commission (SEC) requires brokers to disclose information about how they handle client orders, through rule 606.

Congressional hearings into the GameStop episode may be the first step to some reform, although the likes of Robinhood have insisted that the business model is needed to prevent the return of trading fees.

“Payment for order flow helps cover the costs of running our business and offering commission-free trading to customers,” Robinhood CEO Vlad Tenev told the House Financial Services Committee on Feb. 18.

Valentina Caval is a producer at Yahoo Finance. Brian Cheung is a reporter at Yahoo Finance.

Read and watch more of Yahoo U here

Read the latest financial and business news from Yahoo Finance

Follow Yahoo Finance on Twitter, Facebook, Instagram, Flipboard, SmartNews, LinkedIn, YouTube, and reddit.