One of my mother’s favorite phrases has always been, “If it’s free, it’s for me.” Usually, she was referring to a deal at the grocery store, but recently she could have been referencing commissions for stock trading.
In October, major online brokerage firm Charles Schwab went commission free for trading most stocks and exchange-traded funds (ETF’s). TD Ameritrade, Interactive Brokers, and Fidelity quickly followed suit. This appears to be the culmination of these firms’ “race to the bottom” after decades of declining transaction costs.
The obvious question: If you’re a company in the business of online stock trading, and you cut the cost of trading to zero, how do you make money? Because we all know that corporations, especially in the financial services industry, don’t do things out of the goodness of their collective hearts.
The short answer: They make the majority of their money the way they always have—by taking cash deposits from their account holders and paying out less interest on those cash balances than obtained from whatever they do with that money. The fancy name for this is “net interest margin.”
In the case of Schwab, 57% of the company’s total revenue in 2018 came from net interest margin. Even in this era of low-interest rates, the spread is still very profitable—in 2018, the average that Schwab paid its account holders on cash deposits was 0.28%, while the interest it earned on those balances was 2.57% on average.
Since less than 10% of the company’s overall revenues come from trading commissions, the firm decided to make a preemptive strike that was designed to force its rivals to do the same (which they quickly did).
What firms like Schwab are banking on is that customers will leave enough cash on hand for it to make a profit on the spread, as well as potentially be attracted to other more lucrative products or services, such as trading options (which is not free) or trading on margin.
One thing that jumped out at me in this race to the bottom is how the stock prices of these companies reacted in the aftermath of the announcements— shares of TD Ameritrade, for instance, were down more than 26% the day of Schwab’s press release.
Just further confirmation that the commission business model is continuing to die a slow death.
David Novak, CFP® is a Certified Financial Planner™ at Novak & Powell Financial Services in Pinellas County.
Please note: he is not an attorney and this article
should not be construed as one offering legal advice.
For information about investment decisions and
financial planning, contact him at (727) 451-3440.