Last Updated on April 13, 2021 by Oddmund Groette
If you are serious about trading you must spend considerable time selecting the right broker. It’s an important decision, not only because of costs, but also because of the security of your funds and assets.
In this article, we look at the most obvious issues to look at when you select a broker. This involves your aim, safety of your funds, commissions and costs, software, and support (and more).
What does a broker do? Functions of a brokerage firm
The main function of a stockbroker is to facilitate change of ownership, usually for a small fee. Let’s first look at the primary tasks of a broker to get a better understanding of why it’s important to spend some time in selecting the broker:
- To provide infrastructure and software to facilitate trading.
- To execute trades on the financial markets on behalf of the customer.
- To provide quotes, news, and reports.
- To provide support and help for the customers.
- To provide margin and leverage.
- To store and protect both your capital and your assets.
- To facilitate short positions.
- A broker stores and protects your private data.
Should you choose a proprietary or retail account?
We have previously written about the differences between a proprietary (prop) and a retail account:
If you are a day trader and trade a huge number of shares every day, you most likely can negotiate a better commission rate with a prop firm than you ever get with a retail broker. The downside is that you must give away some of your profits and your capital is at risk. However, you avoid much of the risk by “sweeping” your account every month. If you are very profitable, it might be worth one month of profits.
Moreover, if you know what you’re doing, you can use leverage at a prop firm to increase earnings, much more so than at a retail broker that needs to comply with regulations. The downside is that most stock prop firms only allow day trading.
We believe that prop is a very good choice for those who have little capital, have a proper track-record, and trade very frequently. The advantages most likely outweigh the profit split and risk of your deposit.
Is your money safe in a brokerage account?
The most important factor should be to get a clear understanding of the risk you undertake when you transfer your cash or assets to your chosen broker, being retail or prop.
The way brokers operate differs from broker to broker, but also from region to region. For example, it’s a huge difference between The US and the Scandinavian markets (the two markets that we have extensive knowledge about).
When you buy and own shares, you need to understand who owns the shares. It might seem obvious that you are the owner if you buy 100 shares of Apple, but many are surprised to hear that the broker might be the official owner. You are the beneficial owner, but not the owner in the registry! The real owner of the shares is your broker – not you.
Confused? Yes, it’s not very logical. The reason for this practice is that brokers try to lower costs for commissions by easily facilitating the change of ownership. Mind you, the practice is perfectly legal.
Brokerages in Scandinavia are safe
In Scandinavia the ownership is segregated from the day-to-day activities of the brokers, thus making your assets completely safe. For example, if you buy Equinor on Oslo Stock Exchange via a Norwegian broker, your shares are automatically transferred to a registry that keeps your shares in custody for you. This is 100% separated from the day-to-day business of your broker.
Even though such a system involves two entities, the commission is pretty low: Nordnet, for example, charges 0.035% at the lowest rate with a minimum commission of about 4 USD per transaction.
Brokerages in the US: your capital is at risk (most of the time)
Most assets are held in “street name” which means assets are part of the day-to-day operations of the broker and are a liability towards you in their balance sheet. Obviously, this involves risk on your part if the broker goes belly up. You end up having a claim towards the broker!
To remedy this risk, you have SIPC insurance. This is what SPIC writes on their website:
SIPC protects against the loss of cash and securities – such as stocks and bonds – held by a customer at a financially-troubled SIPC-member brokerage firm. The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. Most customers of failed brokerage firms are protected when assets are missing from customer accounts. There is no requirement that a customer reside in or be a citizen of the United States. A non-U.S. citizen with an account at a brokerage firm that is a member of SIPC is treated the same as a resident or citizen of the United States with an account at a SIPC member brokerage firm…….SIPC protection is limited. SIPC only protects the custody function of the broker dealer, which means that SIPC works to restore to customers their securities and cash that are in their accounts when the brokerage firm liquidation begins.
So, yes, the brokers can “steal” your money if their operations are running at a loss and subsequently fail and you have a deposit higher than the SIPC insurance.
Many brokers offer the option of direct ownership, either digitally or on paper, for a fee, of course. Some brokers don’t have that option, like Interactive Brokers.
Instead, Interactive Brokers keeps much more capital in their balance sheet to offset the bankruptcy risk (more than the regulatory minimum). Currently, IB has about 7 billion USD more than the regulatory requirement. In addition, IB requires higher margins than most brokers to make sure all customers are better protected. We have a significant amount of money in IB and feel comfortable with that, despite the rather dreadful customer support:
Other pan-Europen brokers like Saxo Bank and Degiro offer the opportunity to keep your shares in safe segregated entities.
Make sure you understand how the broker operates and how your assets are stored and protected. The track-record, reliability, and history of the broker are important.
Nonetheless, the business model is liable to black swans, just like what happened in April 2020 when the nearest oil futures contract was trading at negative values. IB’s risk systems never accommodated such a scenario and they lost over 100 million. This is “pocket money” for IB, but it reveals the fragility of the business model and the potential risks.
Commissions are important but beware of free commissions
Obviously, commissions are important if you’re an active trader. However, many are surprised to hear that many major brokerages don’t make most of their revenue from commissions. Interactive Brokers, for example, make most of their revenue from net interest (about 55%), while commissions are only 35%.
Free commissions are hidden costs for the customer
Some brokers, like Robin Hood, offer free commissions. How is that possible? It’s possible because they get paid by routing orders through market makers. This has been a very lucrative business for Robin Hood, at least up until now. Even Interactive Brokers gets paid by routing your orders to market makers.
The market makers make money by pairing/arbitraging buyers and sellers and pocket the difference. This means most customers end up paying more and selling for less than they possibly could. It’s easy to market “free” commissions when you end up paying fees that are “hidden”. Be careful. No one offers anything for free except charity.
Net interest income is the brokers’ biggest source of income
Brokers want to accumulate as much assets as possible. The reason is simple: They use the cash to invest in government securities and make deposits in banks (FIDC protected) to generate interest income. You get compensated for this but at a lower rate. The difference ends up on the income statement of your broker.
Brokers might have inactivity fees
Brokers aim to attract a certain type of traders or investors. Because of this, some brokers might levy inactivity fees. Saxo Bank levies 100 EUR to a funded account that has had zero transactions over a six-month period. Likewise, IB charges 10 USD monthly inactivity fees.
Which markets does your broker offer?
The tendency in the industry is one of consolidation. The moat surrounding the biggest brokers is getting bigger and bigger and the increased regulation and red tape mean smaller players have a hard time competing with the titans of the industry. The trend is one of automation and this requires huge spending in IT and software.
You might only trade stocks today (or something else), but in the future, you might want to expand. For example, we never thought we would be trading options, but over the last couple of years, we have. Luckily, we had an account at IB which offers the cheapest options trading there is for retail clients.
Your broker’s software is important
If you are a quantified trader using software, you should put a great emphasis on the software. Most likely you use some backtesting software and you need a bridge/link to the broker. Does the backtesting software provide that to your broker of choice?
How long (or short) is the hard-to-borrow list at your broker?
You might want to sell shares short, for whatever reasons. Thus, the availability of shares and costs of selling short is vital. All brokers provide a list of stocks that are easy or hard to borrow. If a stock is hard to borrow, can you locate the stocks via support or helpdesk?
How does the broker execute your orders?
As mentioned earlier in the article, you need to understand how the broker makes money. Robin Hood might not be as cheap as it seems.
Support is important when selecting a broker
One often neglected factor is support. We recently had an unpleasant experience with the IB’s “support” desk (a nightmare of many months). IB keeps costs low by automation and this is likely at the expense of accessibility of the support desk. It takes sometimes hours to reach a human and often e-mail are unanswered.
What are current customers saying about your broker?
Most likely, you get a “feel” for how the broker is by reading online ratings. However, don’t focus on the conclusions, but rather on the content of what people are writing. Elitetrader.com still offers, for example, valuable information by reasonably serious traders.
Which broker does Warren Buffett use?
Warren Buffett surely doesn’t use Robin Hood or Coinbase…..
He and Berkshire Hathaway have well-known relationships with several brokers—-and probably many more that are not publicly known. And Berkshire certainly doesn’t keep their shares in “street name”……
Which brokers do hedge funds and other big institutions use?
Interactive Brokers has many hedge funds and other institutions, but most of the bigger institutions use major institutions like JP Morgan, Goldman Sachs, Morgan Stanley etc. The services are much like ordinary retail brokerages, but let the institutions outsource all of the back-office activities making the fund focusing only on investing and trading activities.
You need a substantial bank account to transact business with a prime broker.
Choosing the correct broker might be an influential part of your success or lack thereof. First, check out if prop might be an option for you (if you understand all the risks involved) and only later look at all the options as a retail trader. The fact is, there are not many to choose from. Strict compliance and anti-money laundering rules make brokers merge and others limit foreign customers.