Brokers Profit From You Even If They Don’t Charge for Trading

(Bloomberg Businessweek) -- From sharing pictures to sending email to streaming videos, we’re all used to the idea that many of the things we do online are free. We also know that none of those things are really free—Facebook Inc., Google, and other internet companies have plenty of ways to make money off of us once we sign up. Now another industry has adopted this business model: online stockbrokers..On Oct. 1, Schwab said it would cut commissions on trades for stocks and exchange-traded funds to zero, followed on the same day by TD Ameritrade and ETrade the day after. It was the logical endpoint of a decades-long brokerage price war that began when the U.S. Securities Acts Amendments of 1975 ended fixed trade commissions. Some brokerages took that opportunity to increase their fees, but a former newsletter writer named Charles Schwab charged a comparatively affordable $70 a trade. The discount brokerage business was born, and as technology got better and competition grew more fierce, the common price points kept falling—to about $13 a trade in 2005, then $5 by this year..Some players had already gotten to free. For a few years, the mobile app-based brokerage Robinhood Markets Inc. has offered not only free trades but also a $0 minimum balance as a way to draw in millennial investors. And big financial-services companies have been cranking out other kind of free offers. In 2018, Fidelity Investments Inc. initiated index funds with zero fees, and JPMorgan Chase & Co. rolled out a service that offered clients 100 commission-free stock and ETF trades in their first year. In February, Charles Schwab Corp. and Fidelity announced dueling plans to expand commission-free trades on some ETFs. Then on Sept. 26, Interactive Brokers Group Inc. introduced a service with commission-free trading on U.S. stocks and ETFs called IBKR Lite..Investors in brokerage stocks have been rattled by the latest price cuts, and the share prices of Schwab, TD Ameritrade, ETrade, and Interactive all fell. Schwab stands to lose about $400 million in yearly revenue from eliminating commissions. Which raises the question for customers: Why are the brokers willing to take such a big hit to give me free stuff? “Let’s look at this from a business and economic perspective,” says Peter Lazaroff, co-chief investment officer at Plancorp LLC, a registered investment adviser. “If there are no costs for a product you use, then you are no longer the customer—you just became the product.”.That’s a common one-liner about internet media companies these days. Charles Schwab—the man, not the company—doesn’t shy from such comparisons to tech’s freebie-driven approach. As early as 15 years ago, he says, he began musing about a seemingly wild decision to bring commission rates to zero. “I’ve always tracked Google,” says Schwab, who’s chairman of the brokerage. “Google made the concept of using the internet as the backbone of what you do. You offer the primary service on a free basis and hope to attract enough business, enough clients, that you figure out different ways to make some revenue.”.Unlike internet giants, brokers aren’t chasing eyeballs and personal data. It’s the clients’ money they’re after..One of the greatest sources of revenue for brokers is to invest or loan out the money clients don’t have in play in the market. It works like this: Schwab and other firms “sweep” the uninvested cash in clients’ accounts and place it in one of their banking subsidiaries. They pay customers interest on the money, but it’s nothing to write home about—Schwab’s current rates are as low as 0.12% for small balances and 0.5% for accounts with $1 million or more. Higher rates are available in other savings accounts and money-market mutual funds, including those sold by the brokers, but access to the cash may not be as convenient for an investor just waiting for an opportunity to put the funds to work in the stock market..This idle cash can add up. Schwab clients’ accounts total about $3.7 trillion, according to the latest numbers as of the end of August, with an average of about $265 billion of it earning interest for the company. The money Schwab makes from loaning out its customers’ cash surged to 57% of its $10.1 billion net revenue last year. For TD Ameritrade Holding Corp., the figure last year was 23% of its total $5.4 billion in net revenue. At ETrade Financial Corp. it was 64% of $2.8 billion in net revenue..Schwab says he expects his company also will make up for lost commission revenue with new clients, who may want services the company still charges for, such as investment advice. (On Oct. 10, Fidelity, which also sells investment advice as well as a huge line-up of mutual funds, announced that it too is offering free trades.) Brokerages also make money by catering to investment advisers, loaning customers cash to buy stocks on margin, and lending out securities to short sellers hoping to profit on a decline in prices..And while these companies are no longer charging commissions, that doesn’t mean they aren’t making money from clients’ stock trades. A chunk of their revenue is what’s known as “payment for order flow.” Basically, the brokerages get fees for sending their customers’ buy and sell orders to computerized trading firms such as Citadel Securities and Virtu Financial Corp. Those firms then match buyers with sellers themselves. (The trading firms can make money by picking up the tiny spreads between the prices offered by buyers and sellers, or by trading on any gap between the futures market and stock prices.) Brokers and the trading firms say this process results in a better deal for retail investors..Some financial advisers worry that free trades will encourage regular investors to trade more—and trip themselves up in the process. “I would anticipate those that were on the fence with regard to excessive trading might now be pushed over the edge,” says Charles Sachs, director of planning at Kaufman Rossin, a CPA and advisory firm in Miami. “One thing is for certain in my mind, and that is the game for the retail investor has changed—and not necessarily for the better.” —With Michael P. Regan and Suzanne Woolley.To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net.©2019 Bloomberg L.P.

Brokers Profit From You Even If They Don’t Charge for Trading

Schwab’s move to zero could pay off in the long run.

Choose a plan