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Hi all, Michael here.

Here's my piece from FTT+ earlier today. We're currently running a special where you can get one month for free if you sign up now, so I wanted to send out this note so you can see the type of content you'll get if you sign up. Promise it's worth it, though I might be biased ;)

Before we dive into the topic of this post (neobrokers), here’s a brief recap Q2 VC investment across the UK and Europe.

• $9.5B invested in fintech startups based in the region (the highest quarterly amount invested across the UK & Europe ever)
• 300+ rounds
• 16 rounds above €100M ($120M)
• The UK accounted for 150 of the 300+ rounds, and $3.7B+ invested
• Europe accounted for 154 of the deals and nearly $6B invested
• In Europe Trade Republic took the largest deal, closely followed by Mollie and Klarna

The most active investors into UK fintech were mostly UK based with SeedCamp, Anthemis, MMC and Wise co-founder Taavet Hinrikus leading the way. QED and blockchain investors AU21 Capital and Genblock Capital were the most active US investors.

Speaking of Taavet Hinrikus, on to the main focus of this post, neobrokers! In Europe, payment-for-order flow (PFOF) is essentially banned, so how do no fee brokers make money? Let’s do some digging.

Lightyear

One of the fundings from this quarter in particular caught my eye. UK based Lightyear raised a $1.7M seed round from Taavet to develop an investment platform (i.e. neobroker). This caught my attention for two reasons. First, the company was founded by ex-Wise employees Martin Sokk and Mihkel Aamer and it's great to see more early employees leave larger fintech companies to start their own. I think some of Europe’s most interesting future fintech companies will come from ex-Wise, Revolut, Monzo employees (as they already are). Tracking and investing in these “mafia’s” will likely be a profitable strategy!

The second reason this round stood out was because their former boss invested. When Taavet invests, people in Europe (me included) pay attention. He’s invested in over 50 companies and is one of the region’s most active angel investors.

Lightyear promises “a simple and approachable way to invest your money globally without necessary barriers and fees” which hints at a future beyond stock trading to investing more broadly. Nothing too different from other popular apps in the space so far, but the devil is in the details with neobrokers and how they monetise.

Commission Free

Robinhood pioneered the concept of “commission-free” trading in the US, which has since been copied many times over and forced incumbent brokerage firms to match on pricing. The loss of this valuable source of revenue has given way to an increased amount of PFOF, whereby Robinhood and others will sell their customers' trades to market-makers for execution, earning them $$$. Revenues from PFOF tripled in 2020 at the top four US brokerages to $2.5B. According to Robinhood’s S-1:

“For the year ended December 31, 2020, revenue derived from PFOF and Transaction Rebates represented 75% of our total revenues, and for the three months ended March 31, 2021, represented 81% of our total revenues.”

While brokerage firms in the UK and Europe, such as Freetrade, eToro, Trading 212, Trade Republic, Revolut, BUX, have copied the “commission-free” model, they are not able to monetize via the same PFOF structure. The UKs FCA essentially banned PFOF in 2012 due to the conflicts of interest it creates. While some other European countries like the UK have banned it outright, others haven't. Germany for instance allows PFOF if disclosed to customers and if it improves the customer’s service, which seems to go against the spirit of MiFID II regulations to ensure best execution for customers but technically allowed. This is one of the issues with Europe and regulation i.e. they are applied and interpreted differently across the region, but that's a post for another day...

After the recent GameStop saga in the US, the European Securities and Markets Authority (ESMA) is taking a closer look into the business model of neo-brokers and might take action.

Where's the Revenue Coming From Then?

So if UK brokers can’t make money selling their customers trades with PFOF, how do their businesses work? Some companies (like Freetrade) offer different investment accounts which they charge for, as well as subscription accounts that pay interest and grant access to more investment options. Most monetize via fees (see above). I guess the commission-free trading is only a technicality. Some charge an FX markup when buying foreign stocks, some charge a per trade fee and some, mostly German based, make money via PFOF.

I had planned on doing an experiment to test out each of the brokers’ costs by buying a small amount of a foreign stock at the same time but ran into some challenges related to high minimums (eToro, $50), no longer accepting new accounts (Trading 212) and some services not available in the UK (Trade Republic, BUX).

Going back to FX fees, some companies like eToro and Revolut allow you to hold foreign currencies like USD (this is what Revolut started out as), but others will automatically convert you back to £ or € when you sell a stock. This means you are charged an FX markup on both the buy and the sell. This is the FreeTrade, BUX and Trading212 model, from what I can tell, generating them a healthy profit. Depending on how large each transaction is, paying a flat £1 or €1 may work out cheaper. The recycling of the same funds will mean over time, your money is eroded away by FX fees on the same original investment amount thanks to our good friend compounding. After 4 buy and sell trades, over 3% of your investment will be gone, according to my math just from fees (investments may go up or down in value as well).

While it's difficult to know how many customers trade international stocks, my guess is it's the majority given the lack of brand name tech companies in Europe and the dominance of companies like Tesla, Facebook, Amazon, Apple etc on the homepage of the neobrokers.

So even though a lot of companies promise “commission-free” trading, there is no such thing as a free lunch (sounds familiar). When new companies announce their product is free, the devil is always in the details. For European brokers, that tends to be FX markups or payment for order flow.

That's all for now folks! As always, you can reach me on Twitter.

Michael Jenkins is a current MBA at Berkeley Haas and intern at Acrew Capital, where he is focusing on learning about the fintech and venture capital ecosystem. Michael writes a fintech weekly newsletter, Fintech Across the Pond, providing insights into fintech across the US, UK and Europe as well as hosting the Fintech@Haas podcast. Prior to Haas, he worked as an emerging market debt investor at BlueBay Asset Management in London.