The zero-cost investing model is taking over Wall Street.
Everywhere you look, the cost of participation is being driven towards zero. Fees and commissions are shrinking, to the point they nearly vanish. And when it comes to investing and trading via brokerage firm applications, the “zero” in zero cost is literal. For buying and selling stocks through various brokers and apps, there is often no charge at all these days.
The trend was just reinforced by news of another big merger. Morgan Stanley, a top-tier investment bank, is acquiring online broker E-Trade for $13 billion.
Morgan Stanley’s E-Trade acquisition comes in the wake of Charles Schwab’s deal with TD Ameritrade last November, an even larger one worth $26 billion.
It’s notable that Charles Schwab, a brokerage giant, was able to swallow TD Ameritrade at a knockdown price in 2019. That is because, a month or two prior to the Ameritrade deal, Charles Schwab announced it was moving buy-and-sell stock commissions to zero for most of its platform.
That move hammered the valuation of all online brokerage houses, as it was clear they would have to follow Schwab’s lead. Schwab then took advantage of the markdown it created with its own actions by swallowing TD Ameritrade.
For the casual observer, the trend is puzzling.
Wall Street is arguably the most capitalist place on earth. The online brokers aren’t in business for laughs or charity. So why would brokerage transaction costs fall all the way to zero?
The key is understanding a business model long familiar to Silicon Valley: If the product is free, the user is the product.
Why does Facebook invest billions in staffers, servers, security, and programming, and then give away its main products (Facebook, Instagram, Whatsapp, etc.) at no cost? Because the user delivers attention, and the attention is sold to advertisers.
Why does Google invest billions in staffers, servers, and code improvements, and then give away hugely valuable services like Google Search, Gmail, and Google Maps for free? Again, because the user pays attention, which is valuable to advertisers.
The Silicon Valley giants figured out that, with the right business model, “zero” is the most profitable price for a product — because the scale created by giving away popular products is monetized with ad revenue.
There is one more piece to the puzzle, though, because brokerage houses don’t sell advertising. Charles Schwab and E-Trade don’t monetize the way Facebook or Google does. So what is the twist?
The twist is that, with online brokerages — and with financial services in general — the user’s money is the product. If you are a Charles Schwab customer, Schwab doesn’t monetize your attention. It monetizes the univested cash in your brokerage account.
In finance and banking, there is a concept known as “net interest margin,” or NIM for short. NIM is the profit generated by a spread between interest rates. For example:
- Bob has $10,000 worth of cash in his Schwab brokerage account.
- Schwab invests that $10,000 at a money market rate of 2.1%.
- Schwab pays Bob a money market rate of 1.6%.
- The gap between 2.1% and 1.6% is Schwab’s profit.
- Schwab pockets half a percent — simply for holding Bob’s cash.
Half a percent doesn’t sound like much. But remember that Schwab has trillions of dollars in customer assets under management.
If we conservatively estimate that, say, 10% of that amount is sitting in cash — 10% of customer cash sitting idle in accounts at any given time — Schwab is earning half a percent (or something in that ballpark) on hundreds of billions of dollars.
A half-percent spread on hundreds of billions — when the cash is just sitting there — amounts to a very lucrative business indeed. So lucrative, in fact, that in past quarterly earnings reports, the business of “cash management” has accounted for 50% to 60% of Schwab’s profits.
On Wall Street, if the product is free, the user’s money is the product.
The ability to collect a tiny interest rate spread on hundreds of billions in assets is such a lucrative proposition, it’s worth it to incur huge costs and build out all kinds of infrastructure, from software to banking to client services, on and on, just to attract that money and keep it sitting there.
It’s a similar story with zero-cost stock transactions. If you buy or sell shares of your favorite stock at $20 per share, and you are paying zero commissions, there is probably a high frequency trading firm making five or ten cents off the trade. You don’t pay the ten cents — it comes as a tiny price adjustment on your “fill,” the price at which your buy and sell order is executed.
Once again, averaging a few cents per transaction sounds like a terrible business — unless you scale it to huge size. If you can make a few pennies, on average, on 100,000 transactions per day, let’s say, you’ve got a business worth billions in investment. And billions is what it costs for all those high-tech servers, superfast exchange connections, Ph.D.-level data scientists, and so on.
Does this mean the user is getting ripped off in all this?
In other words, is it somehow shady that online brokers are pocketing half a percent (or thereabouts) on cash management for idle balances, or that high-frequency market makers are taking five or ten cents per share in stock trade execution?
The answer there is “No, not at all.” The zero trend is, by and large, a good one for investors, in consideration of the value for money they are getting.
Schwab and E-Trade, for example, provide a huge array of valuable services to their clients in the form of reliable brokerage services, access to a diverse array of products, fast execution, account insurance, and so on. They work hard to earn the privilege of sitting on that idle cash balance, and the customer gets the benefit of all the innovation and infrastructure Schwab creates — with zero commissions to boot.
On the trading side, the high-frequency trading firm that takes a few pennies per trade provides the service of being a reliable market maker, always available when markets are open, ready to transact with a customer when they want to buy or sell. In finance terms, these electronic market makers provide liquidity to the market — they make themselves available when infrequent buyers or sellers want to transact. As a service, that is easily worth a few cents per share in the profits they collect.
With regard to commissions, it’s also remarkable to think about the multi-decade journey Wall Street has taken. In the 1950s, ’60s, and early ’70s, brokerage commissions were fixed and sky high — until the “May Day” event of May 1, 1975, when fixed commission prices were deregulated. Trading commissions have been on a long march toward zero ever since.
Looking beyond stock transactions, it makes sense to see the zero-cost model taking over more big chunks of Wall Street.
That is because the basic model — “the user’s money is the product” — applies in all kinds of places, and not just brokerage accounts. Wherever customer funds are on hand, there is a potential spread to be earned.
This also explains why consolidation is all the rage; why big fish like TD Ameritrade and E-Trade are getting swallowed by even bigger fish like Charles Schwab and Morgan Stanley; and why the $13 billion E-Trade deal, following the $26 billion TD Ameritrade deal, strongly confirms the trend.
It’s no good to be small in this space; scale is critical and the more you have, the better. In order to make a good living on high-value services provided at little or no cost in exchange for margins of half a percent or less on cash balances, you need a customer asset base in the tens of billions, hundreds of billions, or even the trillions to have a competitive and profitable model.
In a way, this is capitalism writ large, and a nice example of how free markets are supposed to work. In a truly competitive free market system, profit margins are competed away until they approach zero.
It just so happens that, because “the user’s money is the product,” on Wall Street the visible cost of services is now hitting actual zero.
And with Silicon Valley and the cryptocurrency space banging on the door, too, the pace of innovation in “fintech” (financial technology) should only keep accelerating.
TradeSmith Research Team