Schwab’s commission-free trading could be a precursor to a banking revolution. Photo by Bloomberg
WHY are stock brokerages falling over each other to offer free online stock trading? Because they have finally discovered that they can make more money when you, the retail investor, are the product. For years, brokerages had made very little money from your trades. Now, they are saying they can do without all the trading commissions you pay them. Yet, they still need you as a customer and they need all your data, which they want to monetise and turn into cash for themselves.
On Sept 26, discount brokerage Interactive Brokers fired the first salvo by offering zero-fee trades on stocks and exchange-traded funds through its new service IBKR Lite. On Oct 1, giant brokerage Charles Schwab responded by announcing that all securities trading, including stocks, ETFs and options, on its platform would be commission-free. Rivals TD Ameritrade and E*Trade Financial matched it immediately with similar offerings. Brokerage stocks plummeted, with Schwab’s stock down 11%, TD Ameritrade falling 26% and E*Trade 11%. Brokerage stocks are now down 35% to 45% since May last year in a market that is up 8%. The advent of commission-free trading is likely to further jolt the financial services industry, which has sputtered since the 2008 global financial crisis.
To be sure, trading commissions for all sorts of securities have been falling for decades now. The New York Stock Exchange (NYSE), whose history goes back to 1792, first established a fixed minimum commission in 1817. Brokers were legally bound to charge investors a fixed minimum commission — ranging from 5% in the 1920s to 2.5% by the early 1970s on every single trade — whether you were buying S$10 or S$100,000 worth of stocks.
Bracing for ‘May Day’
For over 158 years, despite pressure from investors to cut exorbitant trading costs, NYSE resisted the idea of abolishing fixed commissions. Yet, by the early 1970s, the US’ premier bourse was facing fierce competition from other smaller exchanges, so it pivoted, and on May 1, 1975, dubbed “May Day” by Wall Street traders, allowed volume discounts and negotiated commissions.
In 1963, a young man by the name of Charles Schwab in San Francisco began publishing an investment newsletter. Schwab, who saw himself as a disruptor, took over a small brokerage firm to serve retail investors in 1973. When NYSE abolished fixed commissions in 1975, he rolled out his eponymous discount brokerage. By 1999, Schwab was charging a minimum commission of just US$9.90 for a trade. That was cut to just US$4.95 per trade a decade ago.
Here is how the online stock trading business works: When you buy or sell a stock, ETF or an option on a platform like Schwab, TD Ameritrade or E*Trade, they don’t actually trade for you on some exchange the way old brokerages used to do. They just send your trade to a market maker like Citadel Securities, who in turn pays them a fee to route the trades through for high-frequency trading. So, essentially discount brokerages like Schwab have been for years collecting money from both their retail customers as well as market makers for the same trade. However, the commission they were collecting from you, the retail investor, was just a small part of their total revenue base. If they can get you to trade more now that trading is going to be completely commission-free, as well as get more people to trade on their platform, the money they stand to collect from selling the order flows to different markets and getting a small cut for each order they route through will be a lot more than what they have been earning until now.
It is not just your trades they covet and get paid for by market makers and high-frequency traders; they want all of your data. When you trade regularly with an online brokerage, it gathers a ton of data on you. It knows what banks you use, has an idea of how much disposable income you have, or when you get a bonus, because that is the month you bring in a chunk of new funds for trading every year. The data they collect can then be harvested or sold to others who want to sell you credit cards, loans, mortgages, savings products, insurance, cars and luxury goods — indeed, just about everything. Data is the new gold, and nobody has better data on you than your financial services provider.
In 2013, two Stanford University students, Vlad Tenev, a Bulgarian, and Baiju Bhatt, an Indian, launched a financial technology, or fintech, start-up called Robinhood, focused on millennials buying stocks and ETFs with zero commission. “With an estimated six million users today, Robinhood has been a disruptive force in the retail brokerage industry,” says George Whitridge, an analyst at ARK Invest, a tech-focused fund management firm in New York. Robinhood raised US$323 million (S$446 million), valuing the online brokerage at US$7.6 billion, as part of its latest Series E funding round in March, bringing the total amount it has raised so far to US$862 million. It has shown few signs of slowing down, thanks in large part to its low customer acquisition costs. Bhatt and Tenev pitched their free trading idea to 73 venture capital firms, only to be rejected at every door until Index Ventures threw them a lifeline with a small investment. Aside from selling order flows to high-frequency traders, Robinhood’s revenue base is also buttressed by fees from securities lending as well as a premium subscription option for active traders. On Oct 8, it launched an interest-bearing cash management account for customers, offering one of the highest rates on deposits in the US — 2.05% — while the 10-year US Treasury yield is hovering around 1.5%.
Robinhood makes more than 40% of its revenues from selling its order flows, a controversial practice highlighted in Michael Lewis’s Flash Boys: A Wall Street Revolt, notes Whitridge. “As zero-fee commissions boost order flows, selling them to high-frequency traders could offset some of the lost commissions in this increasingly disrupted part of the financial market,” he says. “Robinhood earns ~S$0.00026 in rebates per dollar traded. That means if you buy a stock for S$100, Robinhood earns 2.6 Singapore cents from the market maker. Other brokerages earn rebates and charge you a per-trade commission fee,” Tenev revealed in an open letter to clients last year. But its zero-commission offering has enticed enough investors to turn it into a formidable challenger.
The financial services landscape is being transformed as regulators lower the barriers to entry by issuing digital banking licences, opening up access to customer data and helping collapse the cost of technology for start-ups. Armed with data and tools such as artificial intelligence, machine learning and data analytics, fintech firms are blazing a trail offering cheap, targeted advice to customers around the world that neither incumbent banks with their legacy infrastructure nor the digital-only banks can deliver. Among them are household names such as US-based PayPal Holdings, Square, Robinhood and Stripe, China’s Ant Financial, Europe’s Adyen, Japan’s Line Corporation and India’s PayTM.
Robinhood may be bleeding money by the bucketloads right now, but if six million mostly young millennial investors are actively trading, saving, investing and buying an array of financial products on its platform, there are plenty of ways to monetise them. For an upstart, it has a lot of time on hand too. In consumer finance, it is about the cost of acquiring customers. Banks such as JPMorgan Chase & Co, Wells Fargo and Bank of America in the US, Singapore’s DBS Group Holdings and Malaysia’s CIMB Group Holdings and Malayan Banking understand that. They cannot lose any customers to upstart free trading platforms that are acquiring scale and expanding into mortgages, credit cards and deposits because getting them back as bank customers can be very costly. And once the challengers have the banks’ customers, they will find it easier to sell them a range of products.
San Francisco-based Schwab, now a diversified bank holding firm, has long used technology to forge ahead as a disruptor. Schwab also has scale with over 12.1 million active brokerage accounts, 1.7 million corporate retirement account participants and US$3.7 trillion in client assets under management. Interest income now makes up nearly 60% of its revenues. One reason Schwab was able to embrace the new model is that trading commissions had plunged to just over US$100 million, or 3.5% of its total annual revenues. Apart from margin lending, it earns most of its money from selling insurance and fees from market makers to whom it routes the trades. TD Ameritrade, on the other hand, made over 22% of its revenues from trading commissions while E*Trade gets 16% of its revenues from the same.
What’s next? More free online trading apps are coming, threatening to transform the business models of brokerages, wealth management firms and banks. Square has been testing free trading on its cash apps for months and expects to roll them out publicly soon. The StockTwits free stock trading app is expected to go live within weeks. Goldman Sachs’ consumer finance unit Marcus is also reportedly planning to launch a free online trading app. JPMorgan and Bank of America, which already have some free trading, are unlikely to sit idly by and see their wealth management clients bolt to Robinhood or Schwab. Southeast Asian investors do not yet have access to commission-free trading of stocks, ETFs or options; it is only a matter of time that a Robinhood-like disruptor emerges. Potential challengers know they can harvest clients’ data, earn a nice spread on what they pay for cash held in brokerage accounts and charge on margin loans, and still thrive in a commission-free trading world.
So, what comes next after free unlimited stock trading? For now, you are unlikely to get paid to trade on an online platform, but because you are now the product, you might earn loyalty points each time you trade or buy another financial product, which you can then cash for things such as flights, hotel stays or other goodies. Being a product has its own rewards.
Assif Shameen is a technology writer based in North America