By Sean Choi
“From day one, my passion has been to make investing easier and more affordable for everyone.” – Charles Schwab
On October 1, 2019, brokerage firm Charles Schwab announced that they were lowering the price of their commissions for buying and selling stocks online from $4.95 to $0 on October 7. A brokerage firm is a company that connects buyers and sellers to stock exchanges so that they can trade with each other. Commissions are fees investors pay to engage brokers to find them a buyer or seller. They also allow consumers to trade stocks, bonds, ETFs, mutual funds, and other types of investments and securities. Shortly after Schwab announced this, other brokerage firms including TD Ameritrade, E*TRADE, and Interactive Brokers announced they were slashing their commissions to $0. This makes trading stocks free.
Commissions account for 3-4% of Schwab’s net revenue. That number may seem low, but Schwab’s shareholders did not take the news lightly as a sell-off ensued, taking the stock price down almost 15%. Schwab’s competitors, E*TRADE and TD Ameritrade rely on commissions for 17% and 15-16% respectively of their revenues. This led to shareholders punishing their stock prices more severely than Schwab as E*TRADE’s stock fell 7% and TD Ameritrade fell about 22%.
While the major brokerage stocks dropped with Schwab’s announcement of zero commissions, they’ve rebounded since.
Competition Leads to Lower Prices
It seems counterintuitive for brokerage firms to eliminate commissions because that is how they make money. But, due to competition, it also seems like they don’t have much choice. With the rise of the startup Robinhood, which offers stock trading for free, i.e. $0 commission, many people, especially millennials, have joined Robinhood and started investing in the stock market. Although Robinhood lacks some features of a regular brokerage firm, like analyst reports, it allows people to invest in the stock market without having to pay commissions, which negate from their returns.
Robinhood helped democratize investing by offering free stock trading. But Schwab has turned the tables by being the first major brokerage firm to offer free, zero-commission stock trading. This should place pressure on Robinhood since many of the other major brokerages have followed Schwab’s lead by eliminating commissions. These firms offer more features than Robinhood by offering other financial products, such as financial advisors and retirement accounts. These give less of an incentive for consumers to go to Robinhood. Because these firms rely on scale, or the advantages/disadvantages a business has as it grows larger, to bring commission-free trading, consolidation could occur. Consolidation refers to businesses seeking to merge or acquire other companies. In the brokerage industry, a possible acquisition candidate is E*TRADE because commissions are a major part of its revenues.
Upsides and Downsides
The shift to eliminating commissions is a major win for consumers. Eliminating commissions further lowers the barriers to investing, potentially leading to more people investing in the stock market. Whether you’re a trader or an everyday investor, the end of commissions could mean hundreds of dollars saved.
However, there are some downsides to eliminating commissions. Removing commissions makes it easier for investors to make risky or speculative trades because they don’t have to worry about commission fees. Fees can make investors pause and consider whether they’re making a good investment. It could also make long-term investing less attractive since investors can now buy and sell stocks whenever they feel like it without considering a long term strategy.
The Future Business Model
While eliminating commissions majorly changes the brokerage business model, some firms are adapting to new business models. For example, Schwab takes uninvested cash from clients’ accounts, like dividend payments, and puts in a sweep account. A sweep account is a bank account that transfers cash into safe and higher-yielding investments such as money market funds. Money market funds are funds that invest in short-term debt and cash. They are considered to be very safe investments. While brokerages will pay you interest, it’s often very low, and they loan out the money at higher rates and then pocket the difference. Brokerages effectively will make money the same way banks do. Brokerages may also start focusing on selling you other financial products like financial advisors and checking accounts to make up the lost revenue. These financial products are lucrative and “sticky” since you’re more connected with the brokerage firm by using their other products.
A Win for the Consumer
While there are some downsides to the elimination of commissions, this is a major win for investors and consumers. The barriers to investing have been knocked down and now, meaning people have much more access to investing. Robinhood paved the way by offering free stock trading and now, the rest of the competition has caught up.