Charles Schwab (NYSE:SCHW) has sent shock waves around the brokerage industry today with its newly announced price cuts. Trades that formerly cost $8.95 on stocks will drop to just $6.95 going forward.
TD Ameritrade (NASDAQ:AMTD) and E*Trade (NASDAQ:ETFC) are still up at $9.99 per trade. However, Fidelity is at $7.95 per stock trade. Thus, this move puts Charles Schwab into the lowest position among the more popular retail-orientated online brokers.
This has, as you might expect, sent the shares of the brokerage stocks down significantly. Here's Schwab:
The others are showing similar losses. This takes us to our first question based on this news. Are the brokerage stocks worth buying on today's dip? The answer to that is no, probably not. They've still run up massively over the past year. I own some Schwab stock myself from a mid-20s cost basis purchased in early 2016. Today's dip is hardly noticeable on the chart:
SCHW data by YCharts
The other brokerages show similar massive chart runs over the past year.
That's because brokerages don't really live and die off the base commission rate. Sure, all else equal, brokers would prefer to charge higher rather than lower rates. But this isn't the 1970s anymore, we aren't paying $100/trade; stock brokers aren't living the high life churning customers' accounts.
Instead, brokers profit off more opaque streams of revenue. One of these is payment for order flow, which Wikipedia helpfully explains:
In general, market makers such as dealers and securities exchanges are willing to pay a broker for the right to transact with that broker's clients because they believe those clients will be uninformed traders-retail or other investors who are trading because of emotion or the need to raise cash and not because they know an asset is misvalued.
By purchasing what it expects to be uninformed order flow, a market-maker can buy at the bid and sell at the ask with less risk of trading at a loss than with an informed trader who knows that the market is mispricing the security. Thus, market-makers who pay for order flow can capture the spread while reducing the risk that the spread is too narrow to adequately compensate them for the risk of loss.
This sort of hidden profit stream off uninformed traders is a volume business. A broker would rather handle more volume than competitors, even if they have to cut the commission rate somewhat.
Brokers also profit off activity in other ways. Short selling, for example, allows the broker to charge a fee to borrow stock. The more clients you have, the more you can reap off this revenue stream.
Perhaps the biggest profit lever for brokerages is using client cash. Brokers pay a pitifully low interest rate on customer cash that isn't invested in anything. The brokers can turn around, park this money in higher-yielding alternatives, and keep the difference. Brokerage stocks have ramped since early 2016 largely on the premise that higher interest rates will cause this profit stream to surge.
Schwab by cutting rates is making an active play to collect more customer cash just as interest rates start to surge. It's probably a wise move on its part; though, of course, it sets off a race to the bottom, where everyone else may feel compelled to cut as well.
Brokerages can probably do fine even if commissions approach zero. Millennial-focused brokerage Robinhood is making a go of it with free commissions, aiming to make money mostly off of margin lending at fairly high rates.
Interactive Brokers (NASDAQ:IBKR) has long offered rock-bottom commissions (admittedly with less customer service) and is plenty profitable. It has set an extremely low commission bar with the stock trading at just $1 per 200 shares of stock.
Impact For Us As Investors
If you trade frequently, you should probably already be at Interactive Brokers. Whether Schwab is at $8.95 or $6.95 per trade hardly matters when Interactive is charging just a couple of bucks for most retail stock trades (unless you move high quantities of stock at a time).
Interactive Brokers also has extremely low margin rates, competitive options pricing, and various other more serious perks. If you trade frequently, you're almost certainly paying too much if you're not there or at a specialty options shop if you do lots of covered calls.
If you only trade a couple of times a month or less, there's an argument to be made for sticking with a traditional online broker, particularly if the added level of customer service is helpful to you. However, don't let the lower commission rate bait you into making a lot more trades. Just because something is cheaper doesn't mean we should do more of it.
Food is good for us, alcohol is fine in moderate quantities, and so on. But just because those goods get cheaper in price doesn't mean we should automatically consume more of them. Same with stock trades.
Disclosure: I am/we are long SCHW.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have accounts at Interactive Brokers and Robinhood.