[In]Securities Guest Blog: Money for Nothing by Aegis Frumento

October 10, 2019

Money for Nothing

This week, Chuck Schwab published his memoirs, Invested: Changing Forever The Way Americans Invest . In it, he writes this about himself:

I was an independent investor. I was passionate about the market. I did my own stock research. I believed in taking charge of my own financial destiny. I loved the thrill of the chase. The last thing I needed was some brokers questionable advice about what to buy, and when to buy or sell. And I resented paying for services I wasn't using. I was also deeply frustrated. For I had come to believe that the brokerage business had a nagging problem with conflicts of interests. I knew that the Wall Street big brokerage firms that were also investment banks -- despite their so-called Chinese walls -- couldn't easily put the interests of the individual investors first. The same was true for commission sales people, many of whom made their living by trading in and out of stocks -- not by building up their clients' portfolios.

He was talking about 1975, but his statement is a testament on how the more things stay the same.

His company, funnily named Chas. Schwab & Co., mentioned the book in its press release announcing that henceforth it would charge no commissions on most retail trades. https://pressroom.aboutschwab.com/press-release/corporate-and-financial-news/conjunction-chuck-schwabs-new-book-invested-schwab-remove . The press release makes it sound as if Schwab's move to free trades coincided with Chuck's memoirs, as if it was meant to put that final exclamation mark on Chuck's career. That's a bit of truthless hyperbole; trading commissions have been trending towards zero for some time now, and a number of online execution-only brokers had already gotten there. Still, Schwab was the first brand-name to eliminate retail customer commissions. E*TRADE, TD Ameritrade, and to an extent even Merrill Lynch, soon followed suit. 

There will be more.

So, is this finally the free lunch we are always told does not exist?

On the face of it, zero commissions really does mean that retail customers can trade securities without having to pay for the privilege. But let's not get carried away. There are number of subtleties here that the simplistic notion of free trades tends to gloss over.

First of all, we shouldn't worry too much about Schwab and the other brokerage firms that appear to be giving away their services. Nor should we be too impressed by their generosity. Trading commissions on retail accounts makes up maybe 3 to 4% of the revenues of a large brokerage firm. Yes they'll be giving that up, but you can bet they wouldn't if they didn't think they will more than make up for it elsewhere. 

There is an easy and simple way to think about free commissions. Anyone who took or thought about economics knows that lowering the price of something will result in more of that product being sold. And anyone who has gone shopping on Black Friday knows that steep discounts draw customers. Zero commissions, then, are simply intended to draw more customers to the firm. More customers mean more assets and more trades, and both of those mean more revenues. Those additional revenues, less transparent than the commission on your confirm, will more than make up for the lost commissions.

Consider that more customers mean more assets in the firm. It's a truism that all financial firms -- call them banks, brokerage firms, whatever -- ultimately make money from interest rate spreads. All finance fundamentally involves borrowing money at one rate and lending it out at a higher rate. Brokerage firms do this in part by borrowing uninvested cash from some of its customers to make margin loans to some of its other customers. Any funds in a brokerage account that aren't invested in securities are automatically swept into some proprietary money market fund. The brokerage firm pays interest, but not much. https://www.consumerreports.org/hidden-costs/beware-hidden-costs-of-free-online-stock-trading-programs/.Currently, Schwab pays as little as 0.12% interest on uninvested cash. Meanwhile, it uses some of that cash to make margin loans, for which it charges interest currently as high as 8.825%. Do the math.

Consider too that more customers mean more trading. It's a common misconception that when a retail customer buys or sells a stock, that order is routed directly to the stock exchange. It isn't. It is routed to a market maker. A market maker is another firm -- or even another division of the same firm -- that is in the business of buying and selling securities off-market, making a profit from the spread between the bid and the ask. It is essentially a form of proprietary trading. For most securities these days that spread is very small, generally a penny or less. And as with any low-margin business, profit depends on volume. 

In order to ramp up the volume that flows through a market-making operation, market makers will pay retail brokers to route their orders to them. This "payment for order flow" has become a sizable component of the revenues of retail brokerage firms. Zero commissions should increase the firm's assets under management, which will increase the firm's volume of order flow and the revenues it gets for directing it to one market maker or another. https://www.benzinga.com/analyst-ratings/analyst-color/19/10/14548159/how-and-why-are-online-brokers-offering-commission-free-trades

But there's more. Zero commissions will also lead to more trades per customer, so the order flow is doubly enhanced. One commentator has suggested that the elimination of trading commissions will now allow independent personal traders to adopt frequent trading strategies that would've been uneconomic if traders had to pay for them. https://theotrade.com/the-truth-behind-commission-free-trading/This may not be so good for investors in the long run. Many studies have shown that the average customer is not profitable trading short-term. https://www.forbes.com/sites/simonmoore/2019/10/01/the-hidden-costs-of-commission-free-trading/#240705062b71But it will surely increase the order flow for which brokerage firms get paid.

But none of that is where the real action is. It won't be long before the marginal cost of effecting stock trades will be zero or close to it anyway. As more securities become cryptosecurities, traded on a blockchain instead of a stock exchange, all of the old ways of trading securities may well vanish. The smart money is recognizing this already. What investors will not pay for executing trades, they will pay for investment advice. For years now firms have been moving towards an investment advisor model, in which revenues (and compensation) are based on assets under management rather than number of trades. In fact, some 60% of retail brokerage revenues now consist of management fees rather than commissions. 

Some have speculated that the elimination of trading commissions -- and with them the old-style broker -- is another step towards the institutionalization of the investment advisor. See https://www.bloomberg.com/opinion/articles/2019-10-03/schwab-commission-free-trading-means-disruption-for-advisers. Maybe. But certainly the trend has been in the other direction, with the most successful broker groups leaving large firms and setting up independent shops. The thought that large firms will be able to leverage technology in ways that smaller practitioners can't seems more of a wish than a plan. The nature of technology is such that, except for processing machines that depend on volume (like order processing), it becomes more widely distributed, not less so, as it matures.  

Schwab's press release got it close to right, then. The move to zero commissions is not revolutionary. Profitability in retail brokerage will continue to depend less on transactions and more on professional advice. And investors who think they have a bargain need to be wary they don't start treating their portfolios like video games now that they can play for free. Customers who are not adept traders -- that is to say, most of them -- will end up losing more than they ever would have paid in commissions. There is still no free lunch. It's not money for nothing when your trades are free.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.