Changing Dynamics in the Discount Brokerage Industry
We live in a time where investors have never been more cost conscious about the fees they are paying and some of the recent changes in the discount brokerage industry reflect this distaste for fees.
In early October 2019, Charles Schwab was first among the major discount brokerage firms in the race to the bottom for trading commissions by announcing that they would be introducing $0 trading commissions on individual stocks and ETFs. This led many of the other big players in the business including TD Ameritrade, E-trade, Fidelity and Vanguard to also move to zero trading commissions. Although trading fees do not generate the majority of these firms’ revenues, they are a major piece. TD Ameritrade for example is planning on forgoing $2 billion in revenue in 2020.
The reason you see this fee compression is all about market share and scope of services. Over the years, there has been an emergence of competitors that offer tech savvy platforms and low fees.
Robinhood, which began operations in 2014, and grew in popularity for pioneering the commission free stock trade, is a great example. Robinhood can offer commission free trades because they rely heavily on a practice called payment for order flow. Orderflow works as follows: when a trade is made, instead of the trade being sent directly to the exchange, the trade is routed by Robinhood to a high frequency trader who will make the trade in return for payment to Robinhood. This practice of subsidizing low commissions through order flow is very prevalent in the US, but is not without controversy. The problem with order flow is that it arguably compromises a company’s duty to obtain “best execution” for its customers in exchange for profit. Robinhood was recently charged with a $1.25 million fine because they weren’t doing adequate due diligence on best execution when routing trades. Order flow is an important part to this story because it is one way these firms can make up lost trading revenue.
Another way companies are making up for lost trading fees is by increasing other service offerings. By lowering fees, they are racing to get more assets and clients in their financial infrastructure. They then can collect fees on things like cash accounts, banking services, loans, and investment products to make up for the reduced fees from trading.
The final dynamic emerging in this space is consolidation. Schwab recently announced that they would be acquiring TD Ameritrade in an all stock deal valued at $26 billion. These two companies account for over 50% of assets among investment advisors, making them a force in the industry. These are two companies that embrace the use of order flow, as TD Ameritrade earned $458 million in revenue in 2019 while Schwab wasn’t far behind. It is unclear at this point if the merger will close, but it’s clear this is not the last we will hear of consolidation, order flow or zero fees.