In the Digital World, Nothing Is Really Free
Disruption in broker world.
In October of 2019, Charles Schwab announced it would offer its clients commission-free trading for all stocks and ETFs on US and Canadian exchanges. Eliminating its $4.95 trade fee set off a domino effect across the other retail brokerages, who dropped their commissions shortly after. Schwab’s move was not really unexpected, though, as Robinhood had caused the real disruption when it launched it’s no commission trading platform six years earlier. It was more a matter of realigning its revenue streams than setting off a shockwave. Nevertheless, breathless coverage of Schwab’s "coup de grace in the retail brokerage price wars" temporarily cratered their share price, along with those of E-Trade and TD Ameritrade. But really, the move had a negligible impact on their bottom line.
Commissions weren't really that important to begin with.
Trade commissions accounted for about 7% of Schwab’s revenue in 2019. E-Trade earned 25% of their revenue on commissions that year and TD earned 16%. Schwab had been moving revenue generation away from commissions for six years, so by acting first, they created positive media exposure, rather than suffering financial hardship sticking up for the little guy. While the commission revenue was still a significant amount of money, it pales in comparison to how much Schwab generated from banking: 60% of their 2019 revenue came from net interest revenue, to the tune of $6.5B.
People don’t think of Schwab as a bank, but it’s the 11th largest bank in the US, with over $342B in total assets. They certainly don’t market themselves as such, but that’s their core business. They have over 31M customers, the vast majority of which are holding cash in their accounts. In 2019, Schwab paid clients 0.34% interest on their deposits, but earned an average of 3.47% through loans and other investments. Schwab’s banking business is also uniquely profitable; it has no brick and mortar overhead, and enjoys exceptionally low nonperforming loan rates, as it loans exclusively to Schwab clients, whose financial standing it knows intimately.
Financial institutions like Schwab, Merrill Lynch and Morgan Stanley offset the loss of trade commission revenue in a wide range of non-banking capacities as well.
How trades get made.
When a client submits a trade (with no commission!) through their online account, they set terms for their broker to buy or sell an asset on their behalf. If the broker owns the asset itself, it can serve as principal, and buy or sell directly to the client, pocketing the difference between its acquisition price and the sale price. It can also impose a markup on purchases or a markdown on sales, further increasing revenue. Brokerages not acting as principals, as is often the case with smaller brokerages, work with market makers to fill orders. Market makers facilitate transactions for a wide range of assets, including mutual funds, ETFS, stocks and bonds. They take on risk by actually buying, selling and holding assets from exchanges, then in turn, providing bids (buy price) and asks (sell price), and setting the market size. Market makers typically work for financial institutions who profit off of the difference between the bid and ask spread.
You are the product.
In the no commission brokerage world, your trading activity is purchased by financial institutions through a Payment For Order Flow (PFOF) transaction. PFOF is an SEC sanctioned concept originally created by none other than Bernie Madoff in 1991, ostensibly to create liquidity in the markets. It’s a transaction in which brokers are paid by market makers to pass along client transactions, which they then execute. When market makers hold the asset being purchased, they can optimize the spread between the bid and ask price. In such a scenario, they are the institutional embodiment of the dark pools described in Michael Lewis’ Flash Boys. The consumer gets the price they submitted, but because the market maker can set the bid or ask price, they can execute the trade with the widest possible spread. Additionally, if a market maker sees a confluence of activity around a certain asset or asset class, they can adjust their own exposure based on that information. It’s like front running, but legal.
Nothing is free.
Five years ago, robo-advisers were cheap. Now, they’re free. Investors can receive free asset allocation services, rebalancing, equity trades, and in some cases, limited education planning and tax-loss harvesting services, from a number of different providers. Free robo-advisers are typically operated by or partnered with a financial institution and make money by steering investors towards proprietary ETFs and mutual funds which charge management fees. In some arrangements, robo-advisers receive direct payments for such redirection. They also allocate a percentage of assets to cash to make rebalancing easier, and so they can invest it. It’s not quite the same tactic Facebook uses, where your likes and shares are run through an algorithm to build a monetized engagement silo, but the scaled up leverage is similar.
There is always a price for using a service. In the case of equity transactions, the cost has moved from direct commissions paid to a broker, to PFOF, where brokers pay market makers for liquidity. The price you pay for the convenience of managing your retirement savings, banking and taxable portfolio all in one place is not getting the best price possible on your trades or a competitive interest rate on your cash.
The truth is that for most investors, purchasing shares that are a few cents higher than what a high frequency trader could get, or earning .34% versus 1% on your cash balance won’t really matter to their long-term financial plan. The notable distinction between the services provided by a robo-adviser and that of an RIA are their intentions. A robo-adviser is focused on optimizing its profit margin on your account whereas an RIA's focus in on optimizing your portfolio for your objectives and integrating it with your financial plan. This underscores a point we've made before - it’s always a good idea to understand what a company’s core business is and how it makes money before you sign up for a "free" account.
If you’d like to discuss your portfolio, cash deposits or financial plan, schedule a meeting with one of our fiduciary advisers, at no cost or obligation.
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of the firm's fiduciary service approach and directs all client engagement, service integration and investment management practices.
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