On Tuesday, the discount brokerage Charles Schwab announced it will cut its commission on online stock and exchange-traded fund trading, currently $4.95 per trade, to $0. TD Ameritrade followed suit hours later. This is part of a broader trend in the brokerage industry toward free services, including no-fee index funds. Schwab also offers a fee-free robo-advising product that will allocate your investments for you automatically.
You may have heard the expression, “If you’re not paying for it, you’re not the customer, you’re the product.” So it makes sense to wonder what the catch is when you’re offered a financial product or service for free. But in this instance, there is a good explanation of how some of these services got so cheap that they’re free, and why that’s a sustainable gain for brokerage consumers who need not pay an offsetting cost to enjoy the benefit of free trades — so long as they pay attention to a couple of issues.
So, how will brokers make money by executing your trades for free? In Schwab’s case, it will continue to make money mostly in the way it already makes the majority of its revenues: by taking cash deposits from its accountholders, and paying out less interest on those cash balances than it gets from whatever it does with the cash. That is, by using the bank that it owns, it will make money the way a bank makes money.
57 percent of Schwab’s revenue last year came from net interest margin, which is to say, borrowing money at interest rates below those at which it lends the money out. Schwab pays accountholders a little bit of interest on their cash balances (0.27 percent, on average, in 2018) and earns a lot more interest by lending those balances out (2.57 percent, again in 2018). If Schwab makes its brokerage product more attractive by offering zero-fee trades, that may induce customers to bring more business to Schwab, including more cash balances, which Schwab can earn a net interest margin on.
In TD Ameritrade’s case, the business model is similar to Schwab, though the structure is different. TD Ameritrade does not own a bank; instead, it partners with other banks (including TD Bank, with which it has an affiliate relationship) to hold customers’ cash on deposit, and those banks effectively pay a portion of the net interest margin back to TD Ameritrade. That accounts for about 28 percent of TD Ameritrade’s revenues.
So a key question for evaluating how good a deal all of this is for brokerage customers is: Are they keeping too much cash in their brokerage accounts? The right amount of cash to hold is not zero: People need to keep cash around for routine bill payments and for emergencies, and many customers use their brokers not just for brokerage but also for cash management (which is to say, checking-style accounts). But Schwab did note in its 2018 annual filing that it expected, as interest rates rose, that some customers would realize they should be moving some of their cash into investments that would make more money for them and less for Schwab.
So that’s one explanation: Schwab (and Ameritrade) can give you free trades because they expect to make money by taking your cash deposits, and that’s fine so long as you’re not leaving too much of your wealth with them in cash. You may wish to explore what brokerage will pay you the best interest rate on your cash, though.
I will offer one additional caveat about Schwab: They are able to offer “free” robo-advising because their robot will put a substantial fraction of your assets in lucrative-for-Schwab cash deposits, typically 6 to 10 percent but sometimes as much as 30 percent. If using this “free” robo-adviser will lead to you holding more cash (and giving up more yield) than you intended, you might be better off paying for a robot to advise you, if you really want a robot’s advice.
Besides deposits, another way brokers make money off free trades is being paid by the party on the other side of the trade. This is called “payment for order flow” and it gives a lot of people pause: If someone else is paying to trade specifically with me, does that mean they know something I don’t about the price we’re trading at? I think Matt Levine of Bloomberg argues convincingly that this practice is harmless to retail investors and even mildly beneficial, because the practice gives the market-making firms who are typically on the other side of your retail-investor trades a greater expectation of stability in the prices they buy and sell at, and therefore allows those market-makers to buy and sell at slightly closer-together prices, which ultimately means you might get a slightly better deal when you buy or sell stock at market prices than you otherwise would. (Plus, the payments for order flow help make it possible for your broker to offer you free trades.)
Finally, any of these free products may be loss-leaders for other, more lucrative products (besides the main one I discussed, cash deposits). Maybe, after picking a broker for free equity and ETF trades, you will become a highly active options trader. Maybe you will borrow on margin. Maybe you will buy mutual funds administered by your broker (ideally, from their perspective, not the no-fee ones). In each case, those reflect independent decisions on your part. Don’t let the promise of free trades lead you into a fund with high fees.
I think the best sign that consumers will come out ahead in the commission price war is what happened to brokerage stock prices today when Schwab announced it was cutting fees to zero: They fell, a lot. Schwab’s shares dropped 9 percent while Ameritrade, which can’t lean as heavily on the deposit business, fell 26 percent. That reflects an expectation of reduced profits in the brokerage industry as brokers collect less in fees from customers. That reduction in brokerage profits should mean that you get to keep a larger share of the returns on your investments.