Companies That Benefit From Rising Interest Rates - Brokers

Summary

• As we look around to try to work out who is going to benefit from rising interest rates, think of brokers.
• Financial market brokers, Robinhood, Schwab, CME Group, the market structure is such that they will benefit.
• The trick is that interest, earnings, from client deposits belong to the company, not the client.

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Who benefits from rising interest rates?

There are a number of candidates for those who should benefit from rising interest rates. Banks, just as the one example, which I'll deal with in another article - low interest rates compress, so higher decompress, interest rate margins.

The sector that people might not realise will benefit is financial market brokers. It's possible to reverse engineer this from the tale of MF Global. It's also inherent in the basic legal structure of how the markets themselves work. Earnings on client deposits and margins belong to the broking company, not the client.

This might well have the largest effect upon Robinhood Markets (HOOD) for reasons we'll come to but it will also affect at least Charles Schwab (SCHW) and CME Group (CME). I've mentioned this elsewhere for Robinhood but this is to widen the point out to note that it affects all companies in this same niche of the market. It's also possible to extend this out to other market participants in the same niche but that's an exercise left for the reader.

The technical point

So, folk put money into their account at a broker. This might just be resting before they deploy it. Or they might have to put up margin on a deal. This is especially so on futures of course. There's cash in those accounts that is.

Cash earns interest so, someone, somewhere has the right to the interest earned by that cash. As it happens, the way the legal structure works is that it belongs to the brokerage company, not the client. In this it's very like - economically it is the same as - the float the banks have. Sure, the contents of our current accounts are pretty minimal and they fluctuate a lot over a month, from payday to that hungry time just before the next one. But average this out over millions of accounts and that's a big chunk the bank can lend out overnight. Which they do. Brokers are in the same position. There might be small amounts individually, but in aggregate there's a substantial position that can be deployed to earn profit.

To reverse this

There's a fun story about MF Global. Back when QE started and interest margins disappeared Jon Corzine got involved with MF Global, a futures broker. Only some of the costs of running MF Global came from commissions. That float, the earnings from it, was the other major income stream. As will happen in competitive markets the existence of the two income streams pushed down commissions to where they didn't cover costs.

Then, tragedy, short term interest rates asymptotically approach zero and MF Global is in trouble. Corzine engineered a speculation in EU government bonds - particularly Greek - in order to increase the margin earned on that float. Nothing, in theory, wrong with the position either. It's just that, as Keynes pointed out, the market can stay irrational longer than you can stay solvent. Which it did and that was the end of MF Global.

This is now reversing

Of course, as the Federal Reserve raises interest rates we're in entirely the opposite position. Those floats at those brokers now become ever more valuable with each quarter point on the Fed funds rate. This becomes an ever increasing source of revenue as interest rates rise.

Who will this affect the most?

The big problem stock in this sector is of course Robinhood. Their customer numbers are off, revenue is declining in this last quarter. Their near only revenue source is payment for order flow, something that doesn't really exist outside US markets - in many others it's not in fact legal.

So, it's difficult to see where Robinhood can go - except as I say there's this second entire income flow arriving as interest rates rise.

My view

I don't say this is enough to make Robinhood a must buy or anything. This is a consideration of something about the sector, not an individual stock. But it is true that there's something there of benefit for the whole sector from rising interest rates.

The investor view

Outside, macroeconomic, conditions do matter and they often do in unconsidered ways. It's been a decade and more since brokerage firms have made significant revenues off their floats. This is now coming back. The single stock I expect to benefit most from this is Robinhood but it should lift revenues right across the sector.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.