What is a brokerage firm?
– A brokerage firm (or broker-dealer) is an intermediary that helps buyers and sellers complete trades in financial instruments such as stocks, bonds, options, and mutual funds. Brokers execute orders, hold assets in custody, and may provide research, advice, or portfolio management. They are paid by commissions, fees, interest, or other revenue streams.
Key definitions
– Commission: a fee charged for executing a trade.
– Assets under management (AUM): the total market value of client assets that a firm manages; used to calculate percentage-based fees.
– Robo-advisor: an automated platform that uses algorithms to build and manage portfolios for clients.
– Fiduciary standard: a legal duty to act in a client’s best interest.
– Suitability standard: a lower regulatory threshold requiring recommendations suitable for a client’s situation.
– Payment for order flow (PFOF): a payment a broker receives from a market maker in exchange for routing customer orders to that market maker.
Main types of brokerages
– Full-service brokerages: Offer human advisers, personalized planning (tax, estate, wealth management), research, and a wide menu of products. Fees can be commissions, hourly/advisory charges, or a wrap fee (an all-inclusive percentage of AUM).
– Discount brokerages (online brokers): Largely self-directed platforms where investors place orders directly. They tend to have lower trading costs and many now offer zero-commission trades for ordinary equity orders.
– Robo-advisors: Low-cost automated managers that construct portfolios (often using index funds/ETFs) and rebalance automatically; some provide optional human advice for a fee.
– Independent vs. captive:
– Independent brokers (often Registered Investment Advisers, RIAs) typically can recommend products across providers and often must follow a fiduciary duty.
– Captive brokers are affiliated with a single company and typically sell that company’s products only; conflicts of interest can be greater.
How a brokerage works (overview)
1. Client opens an account and funds it.
2. Client submits an order (via app, website, phone, or adviser).
3. Broker routes the order to an execution venue (exchange, electronic market maker, or another party).
4. Trade is executed and cleared; the broker arranges settlement and custody of securities.
5. The broker reports confirmations and account statements to the client.
How brokerages earn money (common sources)
– Commissions on trades (decreasingly common for basic equity trades).
– AUM or wrap fees (typically expressed as 0.5%–3% per year).
– Payment for order flow (PFOF) from market makers.
– Interest on uninvested cash balances and interest charged on margin loans.
– Fees on products (mutual funds, bonds, options, broker-assisted trades), account fees, or advisory fees.
– Spread capture when acting as a principal in certain markets.
Checklist: choosing a brokerage
– Define your needs: Do you want advice and planning, simple self-directed trading, or automated management?
– Compare costs: commissions, AUM fees, account or inactivity fees, and fees for special products (bonds, mutual funds, options).
– Understand conflict-of-interest rules: Is the firm fiduciary or suitability-based? Do they receive PFOF?
– Check account minimums and required balances.
– Evaluate available products: stocks, ETFs, options, bonds, mutual funds, IPO access, managed accounts.
– Assess platform and tools: mobile app, order types, research, and execution quality.
– Confirm protections: SIPC coverage, regulatory oversight, BrokerCheck/registration status.
– Test customer service: phone, chat, and availability of human advisers if needed.
Small
Small print: read account agreements, margin agreements, and disclosures (especially provisions for margin interest, order routing, and arbitration). Also check for pattern-day-trader rules, inactivity or transfer-out fees, and whether the broker pays or receives payment for order flow (PFOF).
Additional checklist items
– Settlement and liquidity: Know settlement times (U.S. equities moved to T+1 — trade date plus one business day) and any fund-hold policies for deposits or transfers. Confirm how quickly you can access or withdraw proceeds.
– Fractional shares and odd lots: Does the broker support fractional shares or only whole shares? This affects dollar-based investing and dividend treatment.
– APIs and automation: If you use algorithmic trading or spreadsheets, confirm the availability, limits, and cost of APIs.
– Security and data protection: Two‑factor authentication (2FA), encryption standards, breach history, and account-recovery procedures.
– Order types and routing: Availability of market, limit, stop, stop-limit, and conditional orders; and whether the broker routes orders to market makers or pooled internalizers.
– Educational and research resources: Do you need robust research, screeners, paper trading, or educational modules?
– Ease of exit: Fees and processes for transferring or closing accounts (ACATS transfers), and whether there are transfer-out or account-termination charges.
Step-by-step: choosing and opening a brokerage
1. Define your use case. (Example: active options trader vs. long‑term buy‑and‑hold investor vs. retirement account investor.)
2. Shortlist brokers that match the product set and services you need.
3. Do a cost comparison:
– Trading costs: per-trade commission or per-contract options fees.
– Ongoing costs: advisory or AUM (assets under management) fees, platform fees, data fees.
– Account fees: inactivity, low-balance, or transfer-out fees.
4. Check regulatory status and protections: FINRA BrokerCheck, SEC and state registrations, SIPC coverage.
5. Test the platform: open a demo (paper) account if available; call customer service with a question; try order placement and mobile app flows.
6. Read agreements and disclosures before funding. Look for arbitration clauses, margin terms, and liquidity/withdrawal rules.
7. Open and fund the account: typical requirements are government ID, Social Security number (or tax ID), bank routing and account numbers, and an initial deposit if required. Expect identity verification and possible micro-deposit tests for bank linking.
8. If transferring an existing account, request an ACATS transfer and confirm any outgoing fees from the previous broker. Transfers often take 3–7 business days but can vary.
Worked numeric examples
A. Impact of an AUM fee on long‑term growth (simple annual model)
Assumptions:
– Starting portfolio: $100,000.
– Gross annual return before fees: 7% (0.07).
– AUM fee: 0.75% (0.0075) vs. 0.25% (0.0025).
Model: If the fee is charged annually on assets after returns, annual multiplier = (1 + gross_return) × (1 − fee). Over n years:
FV = PV × [(1 + g) × (1 − f)]^n
Compute 10 years:
– With 0.75% fee: multiplier ≈ 1.07 × 0.9925 = 1.062975; FV ≈ 100,000 × 1.062975^10 ≈ $184,000.
– With 0.25% fee: multiplier ≈
– With 0.25% fee: multiplier ≈ 1.07 × 0.9975 = 1.067325; FV ≈ 100,000 × 1.067325^10 ≈ $192,000.
Comparison (10 years)
– 0.75% fee → FV ≈ $184,000 (from above).
– 0.25% fee → FV ≈ $192,000.
– Absolute difference ≈ $8,000; relative difference ≈ 4.3% of the lower-fee terminal value. Small annual fee differences compound and become meaningful even over
longer horizons.
Longer-horizon example (30 years)
– Formula used: FV = PV × (1 + r_net)^n, where r_net = (1 + g) × (1 − f) − 1. g = gross annual return; f = annual fee (decimal); n = years.
– Assumptions: PV = $100,000; gross return g = 7.0% (0.07) every year; fees are charged annually as a percent of assets after returns (typical for advisory/AUM-type fees).
– Net annual returns:
– f = 0.75% → r_net = 1.07 × 0.9925 − 1 = 0.062975 (6.2975%).
– f = 0.25% → r_net = 1.07 × 0.9975 − 1 = 0.067325 (6.7325%).
– FV after 30 years:
– 0.75% fee: FV ≈ 100,000 × (1.062975)^30 ≈ $623,500.
– 0.25% fee: FV ≈ 100,000 × (1.067325)^30 ≈ $706,000.
– Difference: ≈ $82,500 in nominal terms, roughly 13.2% higher terminal value for the lower-fee option. This shows