Interactive Brokers: Who Survives The Brokerage Price War?

Summary

• U.S. brokerages have been at a price war, and I speculate that eventually commission-free trading will become an industry standard. Brokerages will have to compete through better order execution.
• Interactive Broker's has the best price improvement on trades in the industry through their SMART routing system. This makes Interactive Brokers a strategic investment compared to other brokerages.
• Even if the IB Advantage disappears, Interactive Brokers is still the industry's low cost leader for margin loans.

(Image Source: forketers.com)

2017 was a wonderful year for retail investors. In February, Fidelity Investments announced that they would lower commissions on trades to $4.95, and Charles Schwab (SCHW) followed suit in the same month. E-Trade (ETFC) and TD Ameritrade (AMTD) both responded the following month by lowering their commissions on trades from $9.99 to $6.95. But the main culprit for downward pricing pressure in the brokerage industry has definitely been Robinhood Markets (also referred to as "Robinhood"), which has been offering its customers free trades.

To make matters worse, the price war has also started trickling into the options market. In 2018, Tastyworks (founded by Thinkorswim's co-founder Tom Sosnoff) revealed that they would be capping commissions on options trades at $10 a leg up to 100 contracts. This would bring down commissions for options trading down to $0.10 per contract. Robinhood also made history when they announced that they would be adding commission-free trading for options.

Increasing price competition has led me to speculate that the brokerage price war is foreshadowing a dystopian future for U.S. brokerages where free trades are the industry standard. But I believe Interactive Brokers (NASDAQ:IBKR) has significant advantages over its competitors that will allow it to weather a commission-free future.

SMART Routing, Price Improvement, and the IB Advantage

The IB Advantage is calculated as Interactive Broker's price improvement on orders over the industry average. All values are independently verified by the Transaction Auditing Group, Inc.
(Source: Interactive Brokers Website)

Interactive Broker's primary advantage over other brokerages is their proprietary SMART routing system, which provides the best trade execution in the industry. This advantage is also quantified and publicly reported as the "IB Advantage" semiannually.

IB Advantage US Stocks (100 Shares)(Data from Interactive Brokers Website)

At first glance, it looks like Interactive Brokers has not done a good job maintaining their competitive advantage when it comes to US stocks. The trend even suggests that the IB Advantage for stocks could disappear altogether. The problem is that as trade volumes increase, it becomes harder and harder to deliver significant price improvement to customers. In January of 2018, Interactive Brokers processed more than 10 times the trade volume it processed in the same period in 2008. The problem is akin to Berkshire Hathaway's (BRK.A) struggle to generate above average returns when the company is already worth half a trillion dollars.

In our hypothetical world where every brokerage offers free trades, a five cent improvement over other brokerages seems very small. However, the IB Advantage should not be taken for granted and it is in addition to the industry's execution price improvement. All else equal, something is better than nothing, and there are very few free lunches in investing.

IB Advantage US Options (One Option Contract)

(Data from Interactive Brokers Website)

In the options market, Interactive Brokers has more or less maintained the same level of price improvement (although there is also a downtrend). But if we think about options as a substitute for stocks (one option contract is equal to 100 shares of stock), then Interactive Brokers is still delivering terrific order execution to customers.

Interactive Broker's Other Differentiating Factors

But what if the IB Advantage disappears? If Interactive Brokers loses their position as the low cost leader and their SMART routing system doesn't provide any significant price improvement on orders, how can they compete? Well, Interactive Brokers still has a few differentiating factors that sets it apart from other brokerages.

If you read my previous article on Interactive Brokers, then you already know that they are the best brokerage when it comes to passing on better interest rates to customers. Interactive Brokers charges the lowest margin rates in the industry, and they also offer the highest interest rates on cash balances to customers.

Another interesting tool offered at Interactive Brokers is their stock loan availability program which publicly displays the number of shares available for shorting and any hard-to-borrow fees associated with doing so. No other brokerage offers the same level of transparency when it comes to borrowing securities.

Author's Closing Thoughts

Hopefully this article was more than just an uncomfortable thought experiment for investors who own stock in U.S. brokerages. The brokerage price war has revealed two unfortunate truths. The first being that no one benefits from a price war except the customer. The second is that low prices are not a moat if every other brokerage can also lower their prices. I predict that commission-free trading will eventually become the industry standard. The timing will depend on how much profit brokerages want to generate before lowering their prices.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IBKR over the next 72 hours. 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.