Who Doesn’t Love Free?

October 14, 2019

Early this month Charles Schwab & Co. announced that they would be changing their pricing model for equity trade commissions to $0 per trade. Schwab’s move was soon followed by competitors, including TD Ameritrade and E*Trade.  Fidelity held out for over a week before joining the party. 

The bottom line impact on these custodians will vary.  According to Barron’s, trade commissions only represented 7% of Schwab’s total revenue before the move to $0, whereas the proportion was 17% for E*Trade.

Schwab is not the first to offer free trades. Back in 2013 a startup called Robinhood offered app-based purchases of stock at zero trade cost.  By mid-2018 Robinhood had amassed as many accounts as E*Trade, but without the need for slick TV commercials.  Robinhood’s 6 million account holders have an average age of just 32.  Younger investors seem to prioritize cost over loyalty to a long-established brand.

Of course, there are limits to the generosity of custodians.  At Schwab, non-electronic trades placed directly by telephone, as well as penny stocks, are excluded from the new $0 rate.  Moreover, some custodians have helped their revenues by paying account holders meager yields on sweep cash.  To combat this we have been active in managing our clients’ cash balances using money market funds and Treasury bills. At an even more detailed level the sale of larger dollar amounts of stock will attract trade charges of a few cents per trade. These charges cover Securities and Exchange Commission regulatory fees which custodians like Schwab will still pass back to clients. 

Another way that custodians have indirectly generated revenue is by selling “order flow,” a practice that has drawn some controversy.  When order flow is sold, a custodian receives payment in return for routing trades though a wholesaler rather than directly to an exchange.  Buyers include high frequency traders who might capture fractions of a cent of profit as speedy counter-parties to the trades, creating some small cost slippage for individual investors but adding efficiency to the system.

While free trades are very welcome there could be some unintended negative consequences if account holders trade more often. Studies have long shown that more frequent action can actually reduce returns.  Perhaps the best-known study looked at over 65,000 self-directed investors at a large discount broker in the mid-1990s.  The researchers found that those trading the most under-performed the market over the same period by 6.5% per year, with a group trading less frequently still under-performing by 5%.  By contrast, investors with the lowest monthly turnover in their accounts experienced returns very similar to the market.

We will be watching to see how these changes affect custodians and trading frequency.  Will there be further reductions in custodial fees?  Some have suggested that mutual fund trade costs could be next.  With pressure on profitability there might be consolidation among custodians as scale becomes even more valuable.  And with the cost barrier of trade commissions removed, will account holders run the risk of trading more often? 

Cameron Simonds