America’s e-brokerages scramble to protect margins amid fee war

When Charles Schwab scrapped commissions to trade US stocks this month, cutting its fee from $4.95 to zero, it opened up a new front in a gruelling price war.

Schwab stock dropped a tenth on the day but its rivals, who hastily matched the move of the San Francisco-based group, suffered even more. TD Ameritrade shares lost a quarter of their value, while E*Trade lost 16 per cent. By the end of the week billions of dollars had been wiped from the combined value of the trio.

The decision by Schwab — America’s biggest listed online brokerage, with more than 10m active accounts — to eliminate fees for trading stocks, exchange traded funds and listed options may prove smart, over time. Not only did it hurt its nearest rivals, which derive a bigger share of their revenues from trading commissions, but the firm laid down a direct challenge to no-cost upstarts such as Robinhood, a much-hyped Silicon Valley “unicorn,” that have chipped away at the incumbents.

Schwab did not want to “fall into the trap that a myriad of other firms in a variety of industries have fallen into, and wait too long to respond to new entrants”, said its chief financial officer, Peter Crawford.

But the key problem now for Schwab and others: how to protect margins. Fee cuts by the online brokers come at a time when they are facing drops in income from falling interest rates, which sap the money they can make from the core business of holding cash on behalf of customers.

Meanwhile, other income streams are under apparently relentless pressure. Across the financial services industry, where it can be hard to distinguish between commoditised products, customers are increasingly reluctant to pay up for anything.

Wealth-management platforms such as Betterment offer low-cost portfolio management, for example, giving everyday investors access to financial markets for just 20 or 30 cents for every $100 invested. Schwab’s move to zero commissions across the board marked a step beyond Vanguard, the $5.6tn-in-assets mutual fund giant, which last year removed trading fees for 1,800 ETFs offered on its platform, joining other fee-free providers including JPMorgan Chase, Bank of America Merrill Lynch and Interactive Brokers.

Analysts are in no doubt that fee compression will continue. ETF provider Salt Financial, for example, won regulatory approval in March for a fund with negative fees for a year as it builds up scale. “People are getting paid to put their money in, just like in a bank account,” said Spencer Mindlin of research company Aite Group, adding that such a feature could extend to stock trades before long. “I wouldn’t be surprised if in the next 10 years the retail investor gets rebated back some of their money.”

As it tries to replace revenues it has surrendered, Schwab is now doubling down on investment advice and guidance, while bulking up in asset management, through acquisitions such as the $1.8bn deal in July to buy USAA Investment Management. Others are grinding down on costs. Tim Hockey, chief executive of TD Ameritrade, said on an earnings call this week that he assembled the company’s senior leadership team to review its strategic initiatives and “reprioritise [them] in light of the new environment”.

The revenue give-up wasn’t helpful at all, but it’s actually a bit liberating in terms of really trying to understand where we can create value for clients and then potentially charge for it

TD Ameritrade will shave up to 7 per cent from its cost base, the company said this week. E*Trade has also announced plans to reduce its annual expenses.

“Individuals can now gain access to the financial markets with zero friction,” Michael Pizzi, chief executive of E*Trade, told analysts last week. “The value proposition for customers is truly extraordinary.”

For the established brokerages, a no-fee world may eventually have benefits, said Rich Repetto, an analyst with Sandler O’Neill in New York. “We haven’t seen all the after-effects of this. People may trade more and the brokerages may be able to fill in the lost revenue,” he said. For example, brokers can receive payment from market makers for directing trades to them.

Analysts note that the brokerage giants have proven adept at protecting profits in the past. Pre-tax margins at Schwab have averaged more than 40 per cent over the past three years, even as fee pressures have mounted, marking a steady increase over the previous five years.

But for now, share prices tell a discouraging tale. Even after a big rebound after the move to zero commissions, shares in Schwab remain about 30 per cent off their May 2018 high point — a period over which the S&P 500 index has gained 10 per cent. E*Trade and TD Ameritrade have each lost almost 40 per cent from respective highs reached in the same period.

The spectre of fee cuts had been a “sword of Damocles hanging over us”, said Mr Hockey of TD Ameritrade, as he tried to strike a positive note on the call with analysts.

“Yes, it was very painful and the revenue give-up wasn’t helpful at all, but it’s actually a bit liberating in terms of really trying to understand where we can create value for clients and then potentially charge for it,” he said.