by Jérôme Malaise, CFA
When the largest US broker, Charles Schwab, decided to cut online stock-trading commissions to zero and enable fractional investing in October last year it sent shockwaves across the industry. This, in addition to the press release announcing the following month Schwab’s $26bn takeover of their largest rival, TD Ameritrade, made it clear that US brokers and, to a lesser extent, their counterparts in other developed countries, absolutely need to reinvent themselves or let disruption take the best of them.
US incumbent brokers offering free stock trading: anomaly or shared trend with their industrialized country peers?
What was predictable since the US Securities Exchange Commission (SEC) ordered the end of fixed commissions in 1975 has now become a reality: trading stocks and ETFs listed in North America online come with zero-commission after powerhouses (Schwab, TD Ameritrade or Fidelity to name a few) and smaller players (e.g. Interactive Brokers, E*Trade or Square’s Cash App) alike decided to match Robinhood’s revolutionary pricing. Apart from Nomura in Japan (through LINE securities, an online brokerage joint-venture with popular messaging app LINE) that charges no commission for trading Japanese stocks, incumbents in other developed countries have yet to catch the no-commission train.
In the UK for instance, Barclays, one of the cheapest established brokers, still charges £6 per trade while Hargreaves Lansdown, the country’s largest online retail brokerage platform, exhibits a price tag twice as expensive at £11.95. Only the famous global challenger bank, Revolut, and three other lesser known FinTechs, eToro, Freetrade and Trading 212, enable you to trade stocks for no commission pending Robinhood’s planned expansion in the UK.
Meanwhile in Canada where the big 5 banks dominate the market and all charge from $10 upward a trade, the pricing of Interactive Brokers’ Canadian arm starts at a more attractive $1 per stock and (most) ETF trades. Besides Wealthsimple, a leading Canadian digital wealth management platform, no other companies operating in the Great White North let you trade both stocks and ETFs for free (Questrade, an independent broker, and National Bank, the country’s 6th largest bank, both offer access to a large number of commission-free ETFs but not stocks yet).
With stock-trading commissions gone in the US, brokers’ reliance on other revenue lines increases
As established brokers forfeit profits from stock-trading fees in the US, they risk becoming over-reliant on interest income and cannot count on the much smaller revenue line generated from payment for order flow (PFOF) (see the revenue breakdown bar chart below). Interest incomes that brokers pocket today are highly dependent on the Federal Reserve’s short term interest rate, a component over which they have zero control. As for the PFOF, this practice is often misaligned with the client’s best execution interest and may be challenged by the SEC one day as MiFID II did in the EU. Then, what can incumbent brokers across the developed world do to reinvent themselves and leverage technological changes to meet customers’ evolving expectations profitably?
Responding to disruption by expanding in the Budget, Save or Borrow banking verticals and/or by changing their business models
The first potential response is by identifying which product(s) or service(s) in the Budget, Save and / or Borrow banking verticals could be worth expanding into and meet the following criteria: 1) desirable for customers, 2) financially viable (either a “loss-leader” or profitable product) and 3) feasible from a technology standpoint. For instance, brokers operating in countries with “rewarding” base interest rates could woo new customers by launching a free and flexible high-interest hybrid checking and saving account, offering a better customer experience and yielding more than traditional banks and competitors as well as potentially enabling clients to earn loyalty points (e.g. with rewards such as a free 2-hour consultation with a financial planner). From there, brokers having attracted significant “deposits” could use this funding source to provide, in partnerships with FinTechs or more traditional lenders, personal loans such as security- or portfolio-backed line of credits with an easy application and fast approval process. This interest rate collected on the loans minus the yield paid on the hybrid checking/saving accounts could provide a more diversified and stable interest income than brokers currently earn.
Another potential way for brokers to go past the commoditization of stock trading is by progressively changing their business model from transaction- to subscription-based and significantly improving the value they provide to customers. The consumer preference, and especially for millennials, is increasingly leaning towards bundled subscription-based services for financial services too after having been widely adopted for other industries (e.g. Netflix for video streaming, Spotify for music streaming or Amazon Prime for same-day delivery, video, music and content streaming). To improve their customer’s trading experience, traditional brokers may be tempted to do it themselves but partnering with agile FinTechs offering a more enjoyable customer journey and niche expertise often makes better sense. For instance, TrackInsight enables asset managers, private banks, financial advisors and online investing platform’s retail clients to effortlessly analyze and select the ETF(s) best suited for their needs (e.g. best tracking difference or ESG Scoring).
Commission-free stock trading will eventually reach other parts of the world and brokers face two choices: sitting idly or having the courage to reinvent themselves
Charles Schwab’s stunning move forced all of their rivals to follow suit and remove stock-trading commissions. This was particularly hurtful for those players whose P&L had a significant exposure on such fees and who hadn’t devised a “plan B.” Eventually this trend will hit incumbent brokerage businesses in developed countries and, putting it bluntly, they face two distinct choices: reinvent themselves through a courageous and profound transformation or “do nothing” and risk becoming a “takeover prey” or going bankrupt. While the first choice does not guarantee success the second one brings in a very high risk for shareholders to suffer significant financial losses.
 Interest income is the difference between the return earned by a broker on investing their customers’ cash balances in low-risk instruments (e.g. money market funds or short-term US government debt) and the interest rate paid to the customers.
 Payment for order flow (PFOF) is the revenue a broker generates by selling their clients’ buy and sell orders to third-parties (usually high frequency trading firms) that will then ensure such trades are executed.
 Singapore, The United States or Canada are among the few developed countries with base interest rates significantly higher than zero, respectively 1.63%, 1.75% and 1.75% (as at January 24th, 2020).
 “Financial subscriptions are coming”, NextWave Consumer Financial Services research report, EY
* Overall commissions earned on stock, bond, derivatives (e.g. options) and FX trades. Stock commissions being by far the largest contributor.
** Other can include fees collected on robo-advisor services, mutual funds or monthly subscriptions for “premium” services etc.