A brokerage connects clients to financial markets, the custodian of brokerage accounts, and the go-between between buyers and sellers, receiving a fee per transaction.
A traditional brokerage, also known as a brick-and-mortar or full-service brokerage, formed the backbone of the financial system. Self-managed portfolios rose in popularity, but trading costs at a full-service brokerage were high, discouraging active trading and favoring low-frequency buy-and-hold portfolios.
Online or discount brokerages emerged at the turn of the millennium. Over the past decade, algorithmic trading and robo-advisories started to disrupt the market.
Regardless of the brokerage, it all begins with a brokerage account. We will discuss the brokerage meaning, describe types of brokerage accounts, and help you make an informed decision with brokerage account examples.
What is the Brokerage Meaning?
Since securities exchanges do not allow individuals to buy or sell directly with them, a brokerage is necessary for access. Without a brokerage, market participants cannot engage with a securities exchange.
A brokerage is a go-between connecting buyers and sellers, ensuring completion of transactions, and maintaining order flow and liquidity. Brokerages ensure market participants can manage portfolios in their brokerage accounts and usually charge a commission per transaction, paid by the buyer and the seller. The exchange, where the brokerage has its membership or direct client transactions, may also pay the brokerage for liquidity services. Alternatively, a brokerage may sell client order flow or function as a market maker.
What are the Functions of Brokerages?
Brokerages offer a series of functions vital to the operation of the global financial system. Some are core operating aspects every brokerage provides. Others are secondary, value-added services, which can provide a competitive edge versus other brokerages, in a highly competitive industry, with new brokerages entering the market every year amid soaring demand. The primary brokerage definition is matching client orders as paid-for intermediaries.
The core functions of brokerages:
1. Brokerage account custodians
- Brokerages are custodians of client brokerage accounts
- They segregate client deposits from corporate funds with well-capitalized and trusted Tier 1 banks, ensuring they cannot use client deposits for internal usage
- All financial transactions take place via brokerages, as clients never engage with exchanges or listed companies
- Brokerages also ensure all corporate actions apply to portfolios, like dividends, mergers, and stock splits
- Unless otherwise specified, brokerages maintain stock certificates on behalf of clients, often via third-party services
2. Trading platforms and investment portals
- Clients require a means of placing orders and managing portfolios, and brokerages provide trading platforms and investment portals
- They can range from simple web-based solutions for buy-and-hold investors, offering a straightforward order ticket to innovative trading platforms and infrastructure supporting advanced algorithmic trading solutions
3. Connecting buyers and sellers, matching their orders
- Brokerages usually attempt to match orders internally before routing them to markets via other brokerages, liquidity providers
- Brokerages acting as market makers will take the opposite side of the transaction, creating a well-known and carefully worded conflict of interest, as they earn directly from client losses
- Sourcing the best buying and selling prices for each asset from multiple liquidity providers unless they are market makers, at which point the brokerages offer internal mark-ups at will
Secondary functions of brokerages:
1. Managed fee-based accounts
- Full-service brokerages offer managed accounts, where clients give their portfolio manager permission to buy and sell on their behalf, for which an annual cost and performance fees, both percentage-based on assets under management (AUM) and performance metrics, respectively, which represent a core service at full-service brokerages
- Online brokers offer a similar but less expensive solution via PAMM accounts, where portfolio managers, often retail traders, or licensed firms, manage their core portfolio, while the PAMM system distributes trades to sub-accounts, also for a fee
- Over the past decade, social and copy trading rose to popularity, allowing retail traders to copy trades of others who sign-up as signal providers, paying a fee for profitable trades
2. Trading tools
- Online or discount brokerages lack the personalized approach of full-service brokerages but more than make up for it with innovative-trading tools, ensuring their clients maintain a competitive edge
- Some brokerages developed trading tools in-house, while many opt for high-quality third-party providers, where the booming industry continues to churn out new competitors as demand surges annually
- They include algorithmic trading solutions and AI-assisted analytics tools and help level the playing field for smaller retail traders to well-capitalized trading firms
3. Research and trading recommendations
- Daily market commentary, in-depth research reports, and actionable trading recommendations offer an in-demand service by many retail clients
- Full-service brokerages usually employ an in-house research team, and some online brokers hire analysts to close the services gap
- Actionable trading recommendations are available at online brokerages and often include third-party services, as they outsource non-core functions to qualified experts
4. Education
- With thousands of beginner investors and traders opening brokerage accounts daily, the need for education remains paramount
- Online brokerages may provide high-quality educational programs, interactive webinars, written content, and one-on-one training sessions, their primary tool to counter the personalized approach by full-service brokerages
- Full-service brokerages began offering introductory educational courses, but they generally focus on selling their fee-based managed portfolios
Brokerage Examples
Many associate a brokerage with financial markets, but other industries rely on brokerages for efficient operations.
Below are just a few brokerage examples:
- Stock brokerage
- Forex brokerage
- Options brokerage
- Credit brokerage
- Real estate brokerage
- Leasing brokerage
- Insurance brokerage
All brokerages provide a similar core service to clients, matching buyers with sellers for a commission of the transaction value, usually with a fixed minimum.
Noteworthy:
- In trading, commission-based brokerages usually maintain lower costs and a better product and services portfolio, with very few exceptions. Beginners should avoid the popular commission-free trap, where brokerages lure in clients, but final trading costs are higher versus commission-based alternatives.
Brokerage Categories
So, what is brokerage? Part of addressing this question contains distinguishing between the brokerage types.
The three main brokerage categories are:
1. Full-service brokerages
- Full-service brokerages, or brick-and-mortar brokerages, represent the old guard of the financial system
- They offer a personalized service, focus on their fee-based managed portfolios, and often employ professionals across finance, including analysts, certified financial planners, retirement specialists, dealing desks, risk managers, and other industry-specialists
- Brokerage accounts at full-service brokerages are expensive and actively discourage high-frequency traders
- They are ideal for retirement accounts, low-frequency investments, and high-net-worth portfolios seeking a passive investment approach
- Within full-service brokerages, most are independent, giving them the freedom to offer clients the best services, but some are captive brokerages, meaning they are affiliates of a mutual fund or insurance company and exclusively sell their products
2. Online or Discount Brokerages
- Online brokerages disrupted the brick-and-mortar brokerages, as they made financial markets accessible to everyone from the comfort of their home, while the addition of mobile trading apps provides freedom to transact in brokerage securities on the go
- Transactions costs are notable lower than full-service brokerages, but a personalized service rarely exists
- Covering the lack of human interactions are a wide range of innovative trading tools, third-party services, and full support for algorithmic trading solutions
- Managed account services exist via PAMM accounts or social and copy trading services
- Education for beginner traders is also available at leading online brokerages
- Highly specialized brokerages like a Forex brokerage, a brokerage for options trading, or a multi-asset one-stop brokerage
- Online brokerages are ideal for active traders, self-directed portfolio management, algorithmic trading solutions, high-volume and high-frequency strategies, passive trading, and leveraged trading
3. Robo-Advisors
- The latest competitor to full-service and online brokerages are robo-advisors, offering a low-cost, fully automated approach to mostly passive portfolio management, but active management strategies continue to increase in quantity
- Percentage-based costs are notably lower versus full-service brokerages
- Many operate portfolios at online brokerages
- Despite the name, robo-advisors usually feature human supervision, especially for risk management
- Entry requirements are low, making portfolio management accessible to all
Noteworthy:
- Many full-service brokerages began lowering trading costs, offering more advanced trading platforms, and developing mobile apps
- Online brokerages began hiring industry professionals to provide personalized services
- The lines between full-services and online brokerages became blurry as both compete and against robo-advisories for growing demand
- Robo-advisors often team up with online brokerages
- Algorithmic trading solutions gather market share faster than any competing approach, and online brokerages fully support their usage
The Difference Between Brokerage vs. Exchange
Exchanges are like a supermarket filled with securities, but shoppers cannot enter them, as only members are allowed to buy and sell. Brokerages are exchange members and pay annual membership fees. They are the go-between between market participants and exchanges, allowing order placement and portfolio management, charging clients a commission, and usually getting liquidity-based compensation.
A Brokerage Account Explained
A brokerage account is where market participants manage portfolios. It is like a bank account, as clients make deposits and withdrawals to and from their brokerage account. It is also a taxable account, as capital gains tax applies on income. Without a brokerage account, investing and trading are impossible.
The Purpose of a Brokerage Account
The purpose of a brokerage account is portfolio management, as it is necessary to buy and sell securities. It serves long-term investors and short-term traders alike and forms the backbone of a financial safety net, including retirement accounts and passive and active revenue streams.
Brokerage Account Categories
The two primary brokerage account categories are cash and margin accounts, and there is no limit on how many an individual can have. Retirement accounts are a separate category with IRAs the go-to choice, and the UK also features tax-free spread betting accounts.
Brokerage Account Examples
Cash accounts are best suited for long-term investors, retirement accounts, and passive investment income. Margin accounts are ideal for active traders.
Cash account example:
- You deposit $5,000
- There is no leverage
- You can buy assets worth $5,000 and only pay a commission when you buy or sell
- No other costs apply for self-managed accounts
Margin account example:
- You deposit $5,000
- The standard maximum leverage for equity trading is 1:20 and 1:500 for Forex trading
- You can trade assets worth $100,000 and $2,500,000, respectively
- Swap rates, or financing costs, apply daily on the borrowed amount
- You cannot lose more than your deposit, as automatic stop-out levels close your positions before your balance reaches $0
- Margin accounts magnify profits and losses
Opening a Brokerage Account Explained
Opening a brokerage account is usually a hassle-free and swift process conducted via an online application.
Here are the steps to opening a brokerage account:
- Research brokerages and find the best one suitable for your needs
- Fill out the online application form, which can take less than 20 seconds, but some brokerages collect data via unnecessary questionnaires, prolonging the process
- Verify your account, a necessary step to comply with KYC/AML requirements, usually passed by sending a copy of your ID and one proof of residency document
- Fund your account and start using your portfolio or have it managed for you
Brokerage Conclusion
A brokerage is necessary to invest and trade financial markets, acting as the go-between connecting buyers and sellers for a fee. Online brokerages are the best choice for most market participants, as costs are notably lower. The infrastructure supports advanced trading strategies, including algorithmic trading solutions, versus buy-and-hold investments at full-service brokers. Online brokers also feature better education for beginners, have innovative trading tools, and offer value-added services.
FAQs
How does a brokerage make money?
A brokerage charges commissions and makes money from spreads, interest income, swap rates on leveraged accounts, liquidity-based compensation, selling order flow, or specialized and custom-tailored services like portfolio management fees.
What are the brokerage fees?
The primary brokerage fees depend on the type of brokerage but can consist of commissions, spreads, swap rates, and portfolio management costs.
Is brokerage charged on both buy and sell?
A brokerage charges clients when buying and selling, as the costs are percentage-based on the total value.
Is brokerage included in the cost of shares?
The cost of shares does not include brokerage fees, which are percentage-based on the total deal value.
How much money do you need to open a brokerage account?
It depends on the brokerage, with some eliminating minimum deposit requirements, while many ask for a minimum between $100 and $10,000.
Is a brokerage account a good idea?
A brokerage is necessary if individuals want to invest and trade, as it is impossible without a brokerage.
Can you lose money in a brokerage account?
Total loss of deposits is possible in a brokerage account, especially by inexperienced retail traders who manage their accounts without spending sufficient time on education.