The End of Trading Fees

It has been popular to characterize declining fees as Wall Street’s “race to zero.” It seems time to declare that race over.

Fidelity Investments was the first across the finish line a little more than a year ago, when it announced a pair of index funds with 0% expense ratios. But it was Charles Schwab & Co. who seemingly marked the race’s end. On Oct. 1, Schwab announced that it would eliminate most online trading commissions. TD Ameritrade followed suit hours later, with E-Trade only a few days behind. Schwab already offered commission-free trades on a variety of exchange-traded funds, but now all ETFs – as well as U.S. and Canadian stocks – will be free to trade.

The question for investors is what this change actually means.

Many consumers have wondered what the catch to Schwab’s new model will be. In the internet age, critics are quick to quote the adage, “If you’re not paying for it, you’re not the customer, you’re the product.” In Schwab’s case, that is oversimplifying. But it is true that Schwab is a business, and it can’t make decisions out of pure philanthropy. So it is worth asking why Schwab made this particular move now.

As my colleague Anthony Criscuolo observed in this space when Fidelity offered the first zero expense-ratio funds, the idea of a loss leader is nothing new in the business world. All sorts of companies sell products and services below market cost to encourage customer engagement or loyalty, hoping those customers will buy more profitable goods or services too.

Trading has become a commodity, ripe for loss-leader status. Schwab’s history, as one of Wall Street’s first discount brokerages, rests on bringing investing to the masses. The rise of index funds and online-only brokers have chipped away at commissions as the main profit center for companies like Schwab in recent decades. Schwab’s leaders recognized this change long before the company axed trading fees. Peter Crawford, the company’s CFO, wrote in a commentary, “It has seemed inevitable that commissions would head towards zero, so why wait?”

Schwab is perhaps better positioned than many other firms to weather this change. In announcing the end of online trading commissions, Schwab noted that the move will equal about $90 million to $100 million less in quarterly revenue, or about 3% to 4% of total net revenue. That’s significant, but hardly insurmountable. Even before this change, Schwab was a brokerage that functioned more like a bank – unsurprising, since its banking arm represents Schwab’s major source of revenue. Last year, 57% of Schwab’s revenue came from net interest margin (that is, borrowing money at interest rates lower than the rates at which it lends). As such, it has treated nonbank services more flexibly for some time.

Ameritrade and E-Trade may face a rougher transition as they follow Schwab’s lead. According to estimates from Bank of America, E-Trade earned about 17% of its revenue from commissions, and Ameritrade about 28%. This means eliminating commissions will be a bigger hit for these firms than it will be for Schwab. Both companies’ stocks faced sharp drops after they announced they would eliminate trading fees: 16% for E-Trade and nearly 26% for Ameritrade (compared to 10% for Schwab).

That said, all three firms – and the other brokerages that will follow their lead – have other ways to make up the loss. They are already facing competitive pressure from upstart offerings like Robinhood Markets Inc. that started commission-free. These services, aimed at young and tech-savvy investors, make money from mechanisms like collecting interest on customer deposits and charging traders who buy stocks with borrowed money (that is, on margin).

This brings us to the other reason Schwab can eliminate commissions: “Free” isn’t always free.

As Jason Zweig explained in a Wall Street Journal column, Schwab is well-positioned to make money off its investors’ cash even without fees. As is common for brokers, Schwab puts clients’ uninvested cash into a “sweep account,” which pays almost nothing in interest, even by today’s low-interest-rate standards. Schwab Bank, like most banks, makes money by lending customers’ deposits at higher rates than it pays. By requiring clients of its robo-advisor service to hold some part of their portfolios in cash, Schwab can further boost its banking business relatively painlessly.

Brokerages without banking arms still have ways to make money on trades without charging investors trading fees, too. Zero-commission brokerages like Robinhood often rely on “payment for order flow,” in which they route trades through online trading firms in return for cash payments. Schwab and other traditional brokers also make money this way. As trading commissions become a thing of the past, it seems likely the brokerages will hang on to this revenue rather than passing savings along to their customers. This does not necessarily mean retail investors are getting a bad deal, though some regulators have expressed concern that paying for order flow could create conflicts of interest.

So eliminating commissions has its upside for brokers. What about investors? While the announcement is not bad news, Schwab’s prior fee of $4.95 per trade was small enough that most investors won’t see a major difference. It’s a symptom of the race to the bottom that the difference between “nothing” and “almost nothing” is already negligible.

A word of warning, though: Investors shouldn’t take the end of trading fees as carte blanche to start trading constantly. Don’t blow up your long-term financial plan because trading fees are gone. Some financial advisers told MarketWatch that they worried that the absence of even modest fees could lead some investors to overtrade or make risky bets. But there is no reason the end of fees should mean the end of your existing financial strategy. A buy-and-hold approach is still the wiser course, and the industry’s move toward fee-free trades does not change that.

The move away from trading fees for stocks and ETFs may have one effect on the behavior of prudent investors: a move toward ETFs more broadly. Many brokerages offer funds, especially passive funds, as either mutual funds or ETFs. If ETFs are free to trade and mutual funds are not – Schwab’s decision to eliminate commissions did not apply to mutual funds bought and sold on its platform – the balance may tip in ETFs’ favor. While actively managed ETFs remain rare, this change could bolster them too.

The end of trading fees is good news, but there is no need to overreact. This change confirms long-evident news about the direction of investing, rather than signaling any sharp turns.

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