18 Jul The Rise Of Digital Brokerages: 3 Things Investors Should Take Note Of
Just a few years ago, buying a US-listed stock would have cost around US$20 in trading fees.
The high minimum fees meant that investors had to put higher cash amounts into each investment to make the most out of the fees paid.
As a result, some investors were put off from investing due to the high capital requirement.
Thankfully, the situation has now changed.
The advent of digital stockbrokers who offer trading for little or no commission has lowered the entry barriers to investing, allowing more people to participate in the stock markets.
Such brokers even offer services such as fractionalising shares, allowing individuals to start investing with just US$1.
These companies also possess digital capabilities that allow them to perform transactions cheaply and more quickly than traditional brokers who may still struggle with legacy systems and manual processes.
Without a doubt, digital brokers will continue to play a huge role in the future of retail investing.
Here are three aspects of digital brokers that you should take note.
The poster child of the new-age brokerage is Robinhood, an American fintech company whose mission is to “democratize finance for all”.
In 2013, Robinhood founders Vladimir Tenev and Baiju Bhatt noticed that traditional brokers paid almost nothing to trade stocks – yet still charged retail investors exorbitant fees.
Because of this, the pair had a lightbulb moment.
They decided to disrupt the traditional players by offering commission-free trading with Robinhood, and in 2019, added fractional share trading to its repertoire.
Robinhood’s initial launch in 2015 was a smashing success.
The app’s launch was initially opened on a waitlist basis, and the list stretched up to almost one million people before the app was even available for download.
Today, Robinhood boasts 17.7 million monthly active users on its platform.
In order to keep pace, industry incumbents such as Charles Schwab (NYSE: SCHW), TD Ameritrade and Interactive Brokers (NASDAQ: IBKR) had to lower fees as well.
Robinhood’s success story has inspired the birth of similar companies such as Singapore-based GoTrade, which offers fractional shares and zero commission trading.
Alternative revenue streams
With trading fees out of the equation, digital brokerages had to find new ways to bring in revenue.
One of the most common ways is to generate interest income from uninvested cash held in customers trading accounts, a method used by Robinhood and GoTrade.
Brokers may also charge foreign exchange fees when investors trade currencies on its platforms.
But that’s not all.
Some brokers also offer subscription plans to investment tools.
An example is Robinhood Gold.
By paying a monthly fee of US$5, Robinhood users can get access to more comprehensive market data, research reports from Morningstar (NASDAQ: MORN), and higher fund deposit limits.
Lastly, many digital brokers now use a controversial method known as payment for order flow or PFOF.
Payment for order flow
Here’s what happens behind the scenes of a trade.
When you place a trade order with your brokerage, your broker takes that order to a trading venue to be matched with a corresponding buy or sell order.
In the past, these trades would be matched on a stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ.
But in recent years, companies such as Citadel Securities or Virtu Financial (NASDAQ: VIRT) have come in as an alternative trade matching platform.
These alternative platforms now handle around 38% of all trades.
Controversy arises when these platforms directly pay brokerages to route trades to them, potentially violating what is known as “best execution”.
According to best execution practices, brokers should be routing orders to markets with the best chance of filling the order quickly, and at the best possible price for its customers.
Regulators are not impressed with the PFOF gimmick.
PFOF is already banned in the UK and Canada, while the US Securities and Exchange Commission is examining the efficacy of such tactics in maintaining fairness for investors.
Get Smart: Rise they shall
Notwithstanding the concern around PFOF, digital brokerages continue to grow rapidly as retail investors get more enthusiastic about buying stocks.
In 2020, retail investors comprised around 20% of equity trading volume, a percentage that has doubled since 2010.
But for these brokers, there is still a long runway for customer acquisition.
A 2020 Gallup poll found that 68% of individuals between the ages of 18 and 29 have not invested in the stock markets at all.
As barriers to investing continue to fall, digital brokers are poised to rise further in their quest to democratize finance.
Disclosure: Herman Ng does not own shares in any of the companies mentioned.