With commissions at zero, do customers or brokers benefit?
Fact checked by Kirsten Rohrs SchmittReviewed by Thomas Brock
While commission-free trades have become the norm for customers of discount online brokers, in October 2019, it was big news. Charles Schwab, E*TRADE, and Ally Invest all cut equity commissions to zero the first week of October 2019, and Fidelity joined the crowd on October 10. Bank of America’s Merrill Edge extended free trading to all members of its Preferred Rewards program on October 21.
The industry had been taking baby steps in that direction for several years. Major online brokers started offering a select list, averaging 50-100+, of exchange-traded funds (ETFs) for no commission back in 2010. In early 2017, Schwab set off a round of commission cuts by lowering commissions to $4.95 from $6.95. This reset the industry’s pricing nexus to a lower benchmark as others began to follow. The major brokers enhanced their commission-free ETF offerings in the wake of those cuts.
By making all stock and ETF transactions commission-free, brokers eliminated the benefit of offering a list of ETFs to their customers that do not incur transaction fees—but they have also eliminated the fees that the fund providers had been paying them. However, as we’ll see, brokers have many other ways of generating revenue, including earning revenue from the influx of new investors drawn to commission-free trades on easy-to-use online platforms.
Key Takeaways
- In October 2019, several discount online brokers—such as Charles Schwab and E*TRADE—began offering commission-free trades to their customers.
- Brokers still charge per-contract fees for options trades, along with fees on futures, forex, bonds, and some mutual fund transactions.
- Brokerage firms also earn revenue from interest on clients’ cash balances, stock loan programs, and various advisory services.
- Some brokers like Robinhood generate a significant amount of their revenue through payment for order flow.
- Commission-free investing and easy-to-use online platforms have lead to an influx of new investors entering the markets for the first time.
Free Commissions Doesn’t Mean Everything Is Free
None of the brokers that cut their equity and base options commissions to zero has completely given up all their commission revenue. Brokers still charge per-contract fees for options trades, and also levy charges on futures, forex, bonds, and some mutual fund transactions.
Jennifer Butler, director of asset management and broker research at Corporate Insight, says, “A lot of this movement is geared towards inactive traders, but I don’t think they’ll make up the revenue by opening new accounts.” She believes that brokers are moving further into providing advice in order to function in an environment free of commissions on stocks and exchange-traded funds (ETFs). When analyzing the robo-advisor offerings available for our 2020 Best Robo-Advisors Awards, online brokers that also offer managed accounts pushed their customers, often not very subtly, into those products.
What About Cash?
A large percentage of a brokerage’s revenue comes from idle cash. If new clients are drawn in by the idea of paying no commission on equity trades, they’ll bring some cash along. Brokers and clearing firms earn interest on idle cash. Some share that interest with the clients, but quite a few keep the majority of interest revenue to themselves.
A look at a broker’s financial statements shows that firms are not dependent only on revenue from trading. According to Schwab’s filings with the SEC, approximately 40% of the company’s revenue came from interest revenue for the three months ending March 2021.
Cash Sweeps
Most brokers offer their customers some kind of cash sweep program, by transferring money at the end of the day into an interest-bearing account. For some brokers, this action is automatic. However, the interest rate offered on these accounts can be quite low, something investors should be aware of if they are hoping to generate income from their cash that is not currently invested in equities.
According to Schwab, holding uninvested cash in a brokerage account is best for short-term situations where the investor is planning to spend the money within a few days or will soon place a trade. Long-term cash should be invested in a higher-yielding option, such as a certificate of deposit (CD) or yield-bearing savings account.
How Do Brokers Make Money Without Equity and Options Base Commissions?
Revenue streams for online brokers come from a variety of sources, including interest on clients’ cash balances as discussed above, but also from stock loan programs, commissions on other products, management fees on advised accounts, and of course, payment for order flow.
Several brokers share the revenue they generate with their clients who hold the stock that is lent out in their stock loan programs. For example, Interactive Broker has a stock-yield enhancement program that enables its customers to earn extra income by allowing the company to lend out fully paid shares of stock held in their account. The firm lends these shares to other traders who want to borrow them in order to sell them short and are willing to pay interest to do so. This interest is then shared between the broker and the customer lending the stock.
Commissions are not going away entirely. Brokers are still charging a $0.50-$0.65, on average, per options contract. Eliminating the per-leg commissions of $4.95-$6.95 saves a lot of money for spread traders, who typically trade multi-leg options strategies. Some brokers continue to charge their base commission to trade penny stocks (OTCBB). Certain mutual fund transactions incur a fee, and there are still commissions charged for bond transactions and trades made with the help of a live broker.
Payment for Order Flow
Payment for order flow continues to generate revenue for most brokers. Some brokers like Robinhood make a major fraction of their income through this practice. Brokers who route orders to generate payment for order flow typically aren’t looking for the best price. Robinhood offered free trading at the start because it thought it could offset lost commission revenue with payment for order flow once it had a substantial base of customers placing trades.
Under SEC Rule 606, broker-dealer’s routing orders on behalf of customers are required to publish quarterly reports that list the venues used for customer orders. You can find these reports on broker’s sites under the heading Rule 606 Reports, though they’re not easy reading. You can also request a report specifying where your own orders were routed for the previous six months from your broker.
Who Wins and Who Loses?
Cutting commissions for trading helps clients of online brokers by reducing their trading fees. Brokers with large banking operations, such as Schwab, are likely to come out winners, as are brokers who can convince their clients to consolidate their assets under a single roof. Corporate Insight’s Butler sees a move to loyalty-based or tiered benefits in order to encourage clients to consolidate their assets, seeing an uptick in offerings where the more money you bring in, the better rewards you get.
While some believe that Robinhood’s platform inspired the move to zero commissions for other brokers, that doesn’t explain why the response from the large brokers took five years from that firm’s launch. Robinhood woke the big brokers up to the idea that newcomers to trading don’t want to pay commissions.
Charles Schwab, the founder and chair of his eponymous firm, said his company made the move to zero commissions in 2019, but was always headed in that direction because, as he told Investopedia, “I wanted to take commissions out of the formula. It gets in the way of good investment performance.”
Note
According to a Schwab study, 15% of all current U.S. stock market investors first began investing in 2020.
The Bottom Line
According to a report by FINRA, commission-free investing is just one of many factors that have helped increase the number of individual investors entering the markets for the first time. While zero fees have eliminated a barrier to entry, new investors report the ability to invest with small amounts of money and the desire to invest for retirement as more important factors for getting into the markets.
Whether you’re a new or seasoned investor taking advantage of commission-free investing, you should still rely on certain basic principles to guide you to long-term investing success. Make sure your portfolio is balanced appropriately across asset classes and geographical locations using an asset allocation tool. Those trades can now be made without the friction of a commission charge, which can only help your returns going forward.
Read the original article on Investopedia.