There's nothing wrong with broker-dealers being profitable, but how those profits are obtained could use a good dose of disclosure. Representatives deserve to know that what they are paying is a true cost and what they are receiving is the best possible commission from a vendor.
First, let's look at the profit centers that are relatively obvious to reps. In addition to the spreads broker-dealers receive from payout grids, there are two other primary sources of broker-dealer profit: revenue sharing and markup.
Revenue Sharing Between BDs and Vendors
Revenue sharing happens between the broker-dealer and the product vendors, so it's of little concern to reps. For example, on mutual funds and variable annuities, broker-dealers will negotiate with vendors to earn basis points (bps) on assets or sales of products their reps sell.
Broker-dealers will typically make 1 to 10 bps on either assets or sales of products, with small firms making only 1 or 2 bps and larger firms making 8 or more. Larger firms also have the ability to make these basis points on both assets and sales as they leverage their scale to obtain more.
On REITs and alternative investments, BDs earn between 1% and 1.5% extra in commissions on those product sales, which is called "marketing reallowance." You may have noticed the increasingly large REIT and alts presence at BD conferences over the last five years—it's simply because these vendors are currently willing to spend more to get in front of reps.
Markup Charges on Clearing Firm Costs
Markups, such as ticket charges, are something that representatives recognize as a profit center when they look at their various costs and see that firms differ on what they charge for them. It may not be apparent how much the markups are, or how extensively the costs incorporate overall costs, but reps recognize that there is a spread between clearing firms' costs and what broker-dealers charge the representative.
For example, a clearing firm commonly charges $1 for postage and handling fees, and the broker-dealer charges between $4 and $7. A stock ticket charge from the clearing firm may be $9, but they charge the rep $19. BD scale is a primary factor in how low a firm is able to negotiate with the clearing firm: Small broker-dealers may be able to negotiate perhaps $12 from the clearing firm on stock ticket charges, while a large broker-dealer can negotiate down to $5.
When broker-dealers have dual clearing, they dilute their ability to negotiate lower costs because their assets are split between multiple clearing platforms. As they grow, they are often able to renegotiate to obtain lower costs from the clearing firm. They may then choose to offer reps a lower ticket charge. However, most of the time, these savings are added to the broker-dealer's profits.
Three Hidden Profit Centers That Need to Be Uncovered
Once you account for revenue sharing and markups, there are several profit center areas that remain well-hidden, with reps unaware that they are paying additional costs or missing out on additional commissions. There are three areas that I regularly research as part of my due diligence on broker-dealers to ensure that the representatives who I consult with get everything they deserve—both for themselves and their clients.
1. Third-party money manager markups. Frequently, reps are unaware that they may be paying management fees that are 10 to 15 bps higher than what the fund manager actually charges. Even broker-dealers' own recruiters often are clueless that their firm marks up the manager's fee.
In 2013, a representative called me, irate at his broker-dealer after calling Fidelity Institutional and inquiring what the management fees were on the managers he used. To his surprise, his broker-dealer was marking up the management fee 10 bps. Also in 2013, I did a due diligence trip to a large, publicly traded broker-dealer. My discussion with the head of advisory services was both refreshing and disturbing when I asked, "Do you mark up money manager management fees?"
The response was refreshing in his frankness, compared with previous heads who would respond as if I had caught them in their underwear, giving me caught-off-guard, uncomfortable responses. The disturbing part was how much they would mark up: "We mark up 10 to 25 bps. If the representative is a large producer, we may only mark up the manager's fee 10 bps. But if it is a smaller producer, we would go with 25 bps."
Prior to this visit, I had been witnessing markups in the 5 to 15 bps range. Further evidence that this markup is kept largely in the dark was a conversation with a money manager wholesaler. The wholesaler shared that some broker-dealers contact them with instructions that if one of their reps asks about the management fee they charge, they should instruct them to contact their broker-dealer because the amount the manager charges is different from what the broker-dealer charges.
