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Nothing Is For Free

August 12, 2020

On October 1, 2019, Charles Schwab announced that there would be no transaction fee for trading stocks or Exchange Traded Funds aka ETFs. According to the “gossip,” this change was planned for quite some time.

This created a domino effect among other custodians. TD Ameritrade, Fidelity, BNY-Mellon Pershing, etc. earned money from these trades so it was part of their revenue stream. When Schwab announced this change, other custodians felt the need to follow suit. As a result, TD Ameritrade stock dropped about 30% which was when Schwab announced their acquisition of the company. Nice to buy them at a 30% cheaper stock price. Do you think this was part of the strategy?

However, is transaction-free really in the best interest of the investor? We all know that nothing is really for free. The question becomes, where does the revenue come from to make up for this revenue loss? And, is it transparent to the investor?

No, it isn’t transparent at all. Below are three ways custodians make up for the lack of transaction fees.

1. Pay to play – you’ll notice mutual funds aren’t included in “free.” There are several reasons. Each custodian is gathering data aggregating all the clients from each advisor that is buying or selling a fund. Then, the total buys/sells are forwarded to the mutual fund company. Understandably, there is a cost to this. How much is actual cost and how much is adding to revenue? Custodians aren’t required to disclose.

The mutual fund company pays the custodian to be on the platform. In exchange for being on the custodial platform, the mutual fund has higher expense ratios passed along to the client/shareholder. Some of these fees are subsidizing the “free” of commissions for stocks/ETFs.

This type of revenue stream is also called Platform Fees but is often referred to as Pay to Play. For instance, according to TradingFront, Inc., if you want to be on the Morgan Stanley platform, it will cost a minimum of $50,000 up to $550,000 for the privilege. The end-user doesn’t see this revenue and no disclosure is required from the custodian.

2. Interest rates – If you buy on margin (taking a loan against your securities – Financial Connections doesn’t use margin for clients), the custodian earns money on the interest rate charged. According to Interactivebrokers.com Schwab charges between 7.82% – 6.57%; E*Trade charges 8.45%- 5.45%. The higher the dollar amount margined, the lower the interest rate.

Interest on cash balances is another way custodians add to their revenue. Briefly, interest on your cash is negligible but the custodian can loan it out earning higher returns. Examples: 2018, 57% of Schwab’s net revenue came from loaning out customers’ money; E*Trade was 64%.

3. Order Flow – Once we input a trade order, how does it actually get processed? There are firms that process these orders and of course, they charge for it. This is another way custodians can make money that is unknown to the investor.

The custodian is paid by the order flow company to execute trade orders. So the custodian is receiving fees for the placement of the order. That is not synonymous with getting the best price for the client to execute the order.

As you can surmise, this is a good way for custodians to increase their revenue at the expense of the investor.

What bothers us most is that we are fiduciaries that require full disclosure to the investor. Custodians have no such requirement. From our perspective, paying a small transaction fee to buy/sell a stock or ETF might actually be cheaper for an investor.

As Financial Connections interviews potential custodians as a result of the Schwab acquisition of TD Ameritrade, we will explore these issues.

 

 

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