What Is a Brokerage Firm? How It Makes Money, and Types

What Is a Brokerage Firm?

A brokerage firm or brokerage company is a middleman who connects buyers and sellers to complete a transaction for stock shares, bonds, options, and other financial instruments.

Brokers are compensated in commissions or fees that are charged once the transaction has been completed.

Most discount brokerages now offer their customers zero-commission stock trading. The companies make up for this loss of revenue from other sources, including payments from the exchanges for large quantities of orders and trading fees for other products like mutual funds and bonds.

Key Takeaways

  • A brokerage company primarily acts as a middleman, connecting buyers and sellers to facilitate a transaction.
  • Full-service brokerage companies are compensated via a flat annual fee or fees per transaction.
  • Online brokers offer a set amount of free stock trading but charge fees for other services.
  • The lines are blurring, with full-service brokers launching phone apps and online discount brokers adding fee-based services.

Brokers may work for brokerage companies or operate as independent agents.

Understanding Brokerage Firms

In a perfect market in which every party had all of the necessary information, there would be no need for brokerage firms. That is impossible in a market that has a huge number of participants making transactions at split-second intervals. The Nasdaq alone has in excess of 30 million trades per day.

Brokerage companies exist to help their clients match two sides for a trade, bringing together buyers and sellers at the best price possible for each and extracting a commission for their service. Full-service brokerages offer additional services, including advice and research on a wide range of financial products.

Types of Brokerages

The amount you pay a broker depends on the level of service you receive, how personalized the services are, and whether they involve direct contact with human beings rather than computer algorithms.

Full-Service Brokerage

Full-service brokerages, also known as traditional brokerages, offer a range of products and services including money management, estate planning, tax advice, and financial consultation.

These companies also offer stock quotes, research on economic conditions, and market analysis. Highly trained and credentialed professional brokers and financial advisers are available to advise their clients on money matters.

Traditional brokerages charge a fee, a commission, or both. For regular stock orders, full-service brokers may charge up to $10 to $20 per trade. However, many are switching to a wrap-fee business model in which all services, including stock trades, are covered by an all-inclusive annual fee. The fee averages 1% to 3% of assets under management (AUM).

Many full-service brokers seek out affluent clients and establish minimum account balances that are required to obtain their services, often starting at six figures or more.

Some full-service brokerages offer a lower-cost discount brokerage option as well.

Merrill Lynch Wealth Management, Morgan Stanley, and Edward Jones are among the big names in full-service brokerages.

Discount Brokerage

A discount brokerage is an online brokerage. The online broker's automated network is the middleman, handling buy and sell orders that are input directly by the investor.

The introduction of the first discount brokerage is often attributed to Charles Schwab Corp., which launched its first website in 1995. Competitors soon appeared.

As they have evolved, the brokerages have added tiered services at premium prices. Fierce competition on the web and, later, on phone apps, have led most competitors to drop their fees to zero for basic stock trading services.

Charles Schwab remains one of the biggest names in online brokerages, along with others including Fidelity Investments, TD Ameritrade,

The same names pop up for mobile brokerage apps, along with newer competitors such as Robinhood and Acorns.

Robo-Advisors

A robo-advisor is an online investment platform that uses algorithms to implement trading strategies on behalf of its clients in an automated process.

It's not quite as insane as it sounds. Most robo-advisors are programmed to follow long-term passive index strategies, although several robo-advisors allow clients to modify their investment strategy somewhat if they want more active management. Some even have human advisors waiting in the wings.

Robo-advisors have their appeal, not the least of which is very low entry fees and account balance requirements. Most charge no annual fee, zero commissions, and set their account requirements to a few dollars.

Access to an advisor comes with a fee, typically 0.25% to 0.50% of AUM per year. That's still far less than the cost of a traditional broker.

Independent vs. Captive Brokerage

If you're buying or selling certain financial products, including mutual funds and insurance, it's important to know whether your broker is affiliated with certain companies and sells only its products or can sell you the full range of choices.

You should also find out whether that broker holds to the fiduciary standard or the suitability standard. The suitability standard requires the broker to recommend actions that are suitable to your personal and financial circumstances. The higher fiduciary standard requires the broker to act in your best interests.

Independent Brokerage

Registered investment advisors (RIAs) are the most common type of independent broker found today.

Independent brokerages are not affiliated with a mutual fund company. They may be able to recommend and sell products that are better for the client.

They are required to hold to the fiduciary standard, meaning that they must recommend the investments most in the client's best interest.

Captive Brokerage

A captive brokerage is affiliated with or employed by a mutual fund company or insurance company and can sell only their products. These brokers are employed to recommend and sell the range of products that the mutual or insurance company owns.

The products they recommend may not be the best choice available to the client.

Is It Worth It to Use a Full-Service Broker?

People who use full-service brokers want the advice and attention of an expert to guide their financial affairs. These are usually complex, as these clients tend to be high-net-worth individuals with complex financial affairs. They are willing and able to pay an average of 1% to 3% of their assets per year for the service.

People who use an online discount broker may feel confident in their ability to handle their own finances and make their own decisions.

How Does a Brokerage Firm Work?

A broker is essentially a middleman. Brokers match buyers with sellers, complete the transaction between the two parties, and pocket a fee for their service.

If you use an online brokerage to buy stock, there's no human standing between you and the transaction. The brokerage software makes the match.

If you use a full-service brokerage, the process is much the same, except that someone else is pressing the keys on the keyboard. However, the full-service brokerage may have identified a good investment opportunity, discussed it with the client, and acted in the client's behalf in making the transaction.

How Does a Brokerage Firm Make Money?

Generally, brokerages make fees for every transaction. The online broker who offers free stock trades receives fees for other services, plus fees from the exchanges.

Full-service brokerages increasingly charge a so-called wrap fee, an all-in-one charge for all or most services, This is usually 1% to 3% of the amount in the client's account per year and covers advisory services and investment research as well as trading fees.

Article Sources
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  1. NasdaqTrader. "Nasdaq Daily Market Summary."

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