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JD Haffner | haffnerjd@gmail.com|October 8th, 2019
Last week, Charles Schwab announced the would be eliminating commissions on stock, ETF, and option products. In the following days, almost every major retail brokerage followed suit. This finally marks the end of the commission price war fought by the major brokerages, including Schwab, TD Ameritrade, and E-Trade, that we have seen over the past few years.
Let’s take a look at how we got here. Many years ago, the only way for individual investors to buy stock was to call into their broker. These brokers commonly made up to $200 dollars per trade. In exchange for that hefty fee, these brokers would commonly call up their clients with ideas and recommendations, hoping to keep raking in more commissions. With the invention of online brokerages and low-cost platforms the middle-man was pushed out, with much fewer of them still remaining today; they are making way less money as well. These online brokerages had low-overhead, could staff less people, and make everyday trading more accessible. Robinhood, a no-fee platform, was created in 2013 but really picked up in the last few years. At their inception, it was assumed that they could not be profitable without commissions. Through short-selling, holding idle-money, and selling order flow though, they were able to create money and bring in more and more investors. Today, it’s safe to assume that pressure from investors moving to Robinhood’s no fee platform is what convinced Schwab, the biggest brokerage in the US with 3.25 trillion in assets under management (AUM), to adopt a no-fee platform and retain their user base.
Charles Schwab (SCHW) currently sits about 15% below where they were before the announcement. TD Ameritrade (AMTD) sits nearly 30% down from before they announced. Other brokers have also fared poorly. But why would company executives all make a move that so negatively affects their stock price. It is their job after all to create shareholder value. The simple reason is I believe customers are wrong. Charles Schwab did not make the wrong move following in Robinhood’s steps, they made the right one. At TD Ameritrade, commission revenues only accounts for 15% of their total revenue so even if all of this revenue was cut out, why was their stock punished 30%. I believe this is because investors see this as the end of brokerage firms, when in reality they will adapt and grow their client base, and that’s what these company’s executives are seeing as well.
Without commissions, brokerages will need to adapt more of a Robinhood type business model. Robinhood makes money first by order-flow, market makers pay Robinhood to route orders through them. Luckily, charles schwab has many loyal customers who will not leave the platform now that they have comparable commission fees. This allows Charles Schwab to continue to route their orders, making a profit, and attract new low fee investors to their platform, expanding this market flow profit. Robinhood also makes money by loaning out shares held by investors. This can be profitable for Robinhood but the average Robinhood investor tends to be a small fish, meaning they are a smaller client, and a more active trader. Charles Schwab and other big brokerages on the other hand have a more mature base. These investors have more money and pursue less trades, making them the ideal people to loan shares from. By adjusting the percentage they give back to these investors, Charles Schwab can potentially make a lot more money in a volatile market. Finally, big brokerages have started to see the money is in wealth management, not day trading. Low commissions will attract more clients to their platforms which are better equipped to convert those clients into higher-fee managed money customers. Robinhood doesn’t have a similar infrastructure to convert these clients.
Big name brokerages, especially Charles Schwab (SCHW) are at a huge discount because of these fundamental changes to their business model. Although not without risks, if these companies can transition effectively and continue to bring in clients to their higher-margin services they will certainly profit more in the long run. I would recommend any investor to do more research on this themselves and consider an investment in these companies.
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