Who wins a brokerage price war?

While commission-free trading has become the norm for clients of discount online brokers, in October 2019, it was great news. Charles Schwab, TD Ameritrade, E * TRADE, and Ally Invest reduced equity fees to zero the first week of October 2019, and Fidelity joined the crowd on October 10. Bank of America’s Merrill Edge extended free trading to all members of its loyalty program on October 21.

The industry had been taking small steps in that direction for several years. Leading online brokers began offering a select list, averaging 50-100, of fee-free exchange-traded funds (ETFs) in 2010. In early 2017, Schwab initiated a round of fee cuts that restored the foundation. of the entire industry. $ 4.95- $ 6.95 commission rate, reducing fees from $ 7.95- $ 9.95. Major brokers improved their commission-free ETF offerings in the wake of those cuts.

By making all stock and ETF transactions commission-free, the brokers removed the benefit of offering a list of ETFs to their clients that incur no transaction fees, but also removed the fees that fund providers had charged them with. paying. However, as we will see, brokers have many other ways of generating income, including earning income from the influx of new investors attracted by low-cost trading on user-friendly online platforms.

Key takeaways

  • In October 2019, several online discount brokers, such as Charles Schwab, TD Ameritrade, and E * TRADE, began offering commission-free trading to their clients.
  • Brokers still charge contract fees for options trading, along with fees on futures, currencies, bonds, and some mutual fund transactions.
  • Brokerage firms also earn interest income on clients’ cash balances, equity loan programs, and various advisory services.
  • Some brokers like Robinhood generate a significant amount of their income through pay per order flow.
  • Commission-free investing and user-friendly online platforms have led to an influx of new investors entering the markets for the first time.

Free commissions does not mean that everything is free

None of the brokers who reduced their stock and option commissions to zero have completely given up all of their commission income. Brokers still charge contract fees for options trading and also charge fees on futures, currencies, bonds, and some mutual fund transactions.

Jennifer butler, Director of Broker Research and Asset Management at Corporate Insight, says, “Much of this movement is targeting inactive traders, but I don’t think they will offset the revenue by opening new accounts.” She believes that brokers are making progress in providing advice to operate in a fee-free environment on stocks and exchange-traded funds (ETFs). When looking at the available robo-advisor offers for our 2020 Best Robo-Advisors awards, online brokers who also offer managed accounts pushed their clients, often not very subtly, to those products.

What about the cash?

A large percentage of a brokerage’s income comes from idle cash. If new clients are attracted to the idea of ​​not paying commissions for stock trading, they will bring in some cash. Brokers and clearing companies earn interest on idle cash. Some share that interest with clients, but many keep most of the interest income.

A look at the financial statements of a broker shows that companies do not depend solely on trading income. According to Schwab’s filings with the SEC, approximately 40% of the company’s revenue came from interest income during the three months ending March 2021.

Cash sweeps

Most brokers offer their clients some type of cash transfer program, transferring money at the end of the day to an interest-bearing account. For some runners, this action is automatic. However, the interest rate offered on these accounts can be quite low, something investors should be aware of if they hope to generate income from their cash that is not currently invested in stocks.

According to Schwab, keeping uninvested cash in a brokerage account is best for short-term situations where the investor plans to spend the money in a few days or will soon take a trade. Long-term cash should be invested in a higher-yielding option, such as a certificate of deposit (CD) or a savings account that generates yield.

How do brokers without capital and option base commissions make money?

Income streams for online brokers come from a variety of sources, including interest on clients’ cash balances as mentioned above, but also from stock loan programs, commissions on other products, administration fees on advised accounts and, of course, payment per order flow.

Multiple brokers share the income they generate with their clients who own the shares that are loaned in their equity loan programs. For example, Interactive Broker has a stock performance enhancement program that enables its clients to earn additional income by allowing the company to lend fully paid shares to their account. The company lends these shares to other traders who want to borrow them to sell short and are willing to pay interest to do so. This interest is then shared between the broker and the client who lends the shares.

Commissions are not going to disappear completely. Brokers still charge between $ 0.50 and $ 0.65, on average, per options contract. Eliminating the $ 4.95 to $ 6.95 tranche fees saves a lot of money for spread traders, who typically trade multi-leg option strategies. Some brokers continue to charge their base commission for trading penny stocks (OTCBB). Certain mutual fund transactions incur a fee, and fees are still charged for bond transactions and transactions made with the help of a live broker.

Payment per order flow

Payment for order flow continues to generate revenue for most brokers. Some brokers like Robinhood earn a significant fraction of their income through this practice. Brokers who route orders to generate order flow payments are generally not looking for the best price. Robinhood offered free trading at first because it thought it could make up for the lost commission income by paying for the order flow once it had a substantial base of trading customers.

Under SEC Rule 606, brokers submitting orders on behalf of clients are required to publish quarterly reports listing the locations used for client orders. You can find these reports on broker sites under Rule 606 Reports, although they are not easy to read. You can also ask your broker for a report specifying where your own orders were shipped during the previous six months.

Who wins and who loses?

Reducing trading fees helps online broker clients by lowering their trading fees. Brokers with large banking operations like Schwab are likely to gain, as are brokers who can convince their clients to consolidate their assets under one roof. Butler of Corporate Insight sees a move towards loyalty-based or tiered benefits to encourage clients to consolidate their assets, seeing an increase in offers where the more money you put in, the better rewards you get.

While some believe that Robinhood’s platform inspired the switch to zero commissions for other brokers, that doesn’t explain why the response from big brokers took five years from the launch of that company. Robinhood woke up big brokers with the idea that newcomers to the trade don’t want to pay commissions.

Charles Schwab, founder and president of his eponymous firm, said his company made the switch to zero commissions in 2019, but he always headed in that direction because, as he told Investopedia, “I wanted to take commissions from the formula. It hinders good performance. return on investments “.

According to a study by Schwab, 15% of all current investors in the US stock market started investing in 2020.

The bottom line

According to a FINRA report, commission-free investing is just one of many factors that have helped increase the number of individual investors entering the markets for the first time. While zero fees have removed a barrier to entry, new investors report that the ability to invest with small amounts of money and the desire to invest for retirement are more important factors in entering the markets.

Whether you are a new or experienced investor who benefits from commission-free investing, you still need to rely on certain basic principles that will guide you to long-term investment success. Make sure your portfolio is properly balanced between asset classes and geographic locations by using an asset allocation tool. Those trades can now be done without the friction of a commission charge, which can only help your future earnings.


READ ALSO:  Definition of equilibrium volume (OBV)
About the author

Mark Holland

Leave a comment: