Back in October, Charles Schwab announced that they are eliminating commissions. There are no free lunches in this business, so how are discount brokers like Schwab making money if what they broker is now free?
No Free Lunch
There’s a common saying in internet media these days:<?p>
“If there are no costs for a product you use, then you are no longer the customer - you just became the product.”
Facebook, Google, LinkedIn, and other internet companies are free to use for this reason. It seems as if the discount brokers are now doing the same by offering core services for free to investors.
Back in October, Charles Schwab announced that they are eliminating commissions on equities and Exchange Traded Funds (ETFs). TD Ameritrade, Fidelity, and E-Trade quickly followed suit. To better understand how they can offer free trading and why they did it, let’s go under the hood to see how the discount brokers make money.
The irony of the discount brokerage business model is that these firms make a killing off the money investors don’t invest in the market. Schwab and others “sweep” idle cash that sits uninvested in client accounts over to a subsidiary or affiliated bank. They pay interest on this cash, but it’s paltry (usually between 0.00% - 0.50%).
Once it arrives at the bank, they either invest it in higher-yielding Treasury bonds or loan it out in the same manner as any other bank. They collect the spread between the rate they earn and the rate they pay out.
For example, if Schwab paid customers 0.10% to use their idle cash to buy a 10-year Treasury bond that yielded 1.80%, they could collect 1.70% (1.80% – 0.10% = 1.70%). While this hypothetical return may seem trivial, sweeping cash is very profitable when trillions of assets are custodied in accounts.
Schwab earned $1.6 billion in revenue during Q3 2019 from this idle cash. This represents 60% of Schwab’s total revenue 1 . Commissions only accounted for 6.3%, so making them a sacrificial lamb seems logical if it can expand their core business.
Think about it this way. If free trading attracts new customers to Schwab, then this will bring fresh idle cash. The more idle cash, the more that gets swept to their bank. They can also collect fees through many of the services discussed below.
Brokers engage in two lucrative forms of lending. The first is margin lending, which allows a customer to invest more than what they have in their account. For example, if an investor had $100,000 in a trading account but wanted to invest $120,000 into the stock market, brokers will create a margin account and lend $20,000 to the investor to cover the difference. The interest rates charged on these loans are relatively high. For example, Schwab charges between 7.575% - 9.325% based on the size of the loan 2 . The second type of lending facilitates short sellers. Those who “short sell” a stock aim to profit on the fall in a stock price. Imagine that Investor A wants to “short” 200 shares of a fictitious stock (ticker: XYZ) at the current price of $100.
The investor enters the sell order online, but since this investor does not actually own the stock, the broker will search other customer accounts to see who has enough shares of XYZ. The broker sees that Investor B owns 500 shares of the stock, so the broker takes 200 shares out of this account and sells them. Investor A is credited with $20,000 in cash (200 shares x $100/share = $20,000) in his account.
If the stock price fell to $60 over the coming months, Investor A could “cover” the short position by buying 200 shares for $12,000 (200 shares x $60/share = $12,000). He then keeps $8,000 in cash, which represents his profit from the trade.
The broker would then take the 200 shares purchased and put it back into Investor B’s account. Furthermore, any dividends paid from XYZ would be taken from Investor A’s account and placed into Investor B’s account for the duration of the trade.
Brokers charge hefty fees for short sales. The rates differ for every stock and change daily, but heavily shorted stocks can easily see fees exceed 50% of the value of the short position.
While some brokers may no longer charge commissions for trading stocks, some still make money from client trades through a process known as “payment for order flow.” When an investor submits an order online to buy or sell a stock through a brokerage account, the order rarely goes directly to the stock exchange. Instead, computerized trading firms pay brokers for the right to execute trades. These companies profit by collecting the “spread” on the transaction.
There are two prices for every stock - the price a buyer is willing to pay (the “bid”) and the price a seller is willing to accept (the “ask”). If the bid price of a stock is $100.00 and the ask price is $100.05, the spread between these two is $0.05 and represents the profit to the party that executes the trade.
This is just like a pawn shop. If an antique is bought by a pawn shop for $30 (the bid), and the shop sells it a week later for $50 (the ask), the shop collects $20 (the spread) for facilitating the transaction.
Firms that pay for order flow are highly specialized at profiting from this spread, and brokers can earn hundreds of millions of dollars annually for selling their order flow.
Some discount brokers offer a suite of proprietary investment products via mutual funds and ETFs. These funds charge expense ratios based on the assets invested over time. Fees can vary greatly based on scope and complexity of the fund’s strategy. The Schwab U.S. Broad Market ETF (ticker: SCHB) is a passive fund that charges 0.03%, or $3 for every $10,000 invested 3 . The Fidelity Emerging Europe, Middle East, Africa (EMEA) Fund (ticker: FEMEX) is an active fund that charges 1.34%, or $134 for every $10,000 invested 4 .
Brokers also offer shelf space to third-party money managers similar to how a grocery store offers its own products next to brand-name competitors. They charge for this shelf space in one of two ways.
The first is by charging commissions on trading mutual fund shares, and these transaction fees can easily be $40 or more per trade.
The second is through a revenue share agreement with the fund provider. This is usually a combination of an annual flat fee plus a percentage of revenue the fund company earns (typically 0.25% or more). Most fund companies pass this cost along to investors, meaning these funds can be more expensive to own (even though it trades commission free).
For example, Vanguard refuses to pay revenue share so they can keep expense ratios low for their investors. Hence, most brokers will charge a commission each time they transact Vanguard funds.
Similar to banks, discount brokers charge fees for a myriad of services such as wiring funds, closing an account, maintaining IRAs, etc. Some of these fees are waived for accounts above thresholds.
The Bottom Line
I own several credit cards that paid big sign up bonuses in the form of airline miles and points. They also offer some amazing perks, and I strategically use them to extract the most value out of every purchase.
For example, one of my favorite credit cards covers the fourth night at any hotel in the world as long as I use this card to pay the bill. This benefit alone has saved me thousands over the years. This same card credits my account for $250 annually towards travel expenses, and another card covers the Delta Airlines Sky Club membership ($495 annually).
Credit card issuers can afford to pay these perks to all cardholders because some cardholders carry high balances that are subject to stratospheric interest rates. In economics, this is referred to as a “positive externality.” Those who carry large credit card balances for extended periods of time create a benefit for those who do not.
American Express, Citi, and Chase also give me huge perks because they are hoping to cross sell me on other services and products. Others may find them beneficial, but I see little value and mostly ignore them.
I use discount brokers the exact same way. I extract maximum value by adhering to three rules that all investors should follow:
- Most brokers offer far more attractive options for investing cash. Explore them.
- Leverage can wipe you out fast, so never trade on margin. Even if you are right, you have to be really right to earn a return above the high cost of the loan.
- Use limit orders to prevent any risk of predatory activity by firms that pay for order flow.
Simply put, I’m a free rider. I enjoy the perks while brokers profit handsomely from day traders and other investors that utilize their more expensive services. Brokers make money and I save money. It’s a win-win.
Commission-free trading just happens to be the new perk. It’s no different than those free toasters that banks used to hand out for opening new accounts. Sure, it’s nice to get something for free, but it’s unlikely that a new toaster or free stock trades will make a big difference over the long run.
Most investors don’t trade enough for the savings to materially impact a financial plan. If anything, it could harm those who feel unconstrained now that trading costs have been eliminated (rarely does more trading equate to better long-term outcomes).
The bottom line is that the rise of discount brokers has been one of the most powerful forces to benefit investors over the last half century. Free trading only adds to their value proposition, but don’t view this as anything more than a perk.
Three Key Points
- Charles Schwab announced that they are eliminating commissions in October of last year.
- Free trading prompted investors to question how these firms make money.
- Discount brokers are excellent options as long as investors use them properly.
- https://content.schwab.com/web/retail/public/about- schwab/schw_q3_2019_earnings_release.PDF
- https://www.schwab.com/public/schwab/investing/accounts_products/investment/ margin_accounts
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