Some Thoughts on "Free"Submitted by Trace Wealth Advisors on October 7th, 2019
Charles Schwab & Co. shook the financial industry last week when it announced that it was going to offer free trading of US listed stocks and ETFs to all of its clients. Schwab trumpeted its move as a win for investors, with CEO Walt Bettinger stating, “This is our price. Not a promotion. No catches. Period. Price should never be a barrier to investing for anyone, whether an experienced investor or someone just starting on the investing path.”
The only problem is there is a catch…actually, there are a lot of them. The removal of explicit trading costs makes their services anything but free and won’t necessarily help break down barriers to investing for the general public. To better understand this, it’s important to contextualize this move by examining both the history of how we got here and how Schwab can afford offer a service so vital to its business for free.
To understand the current state of affairs, you actually need to go back to May 1, 1975, commonly referred to as “May Day” in the financial services business. Before that date, all brokerages charged the same fixed price for stock trades, which ate up a large portion of potential profits, particularly for smaller investors. Subsequent to that date, the SEC allowed market competition to set commission rates, which led to the birth of the discount brokerage industry; while Schwab was founded in 1973, it didn’t really start to gain traction within the industry until the May Day passage.
Once Schwab was in the game, they started by offering commission rates of $70 per trade (considered a swinging bargain at the time!). Since then, commission rates continued on a slow but consistent march lower until last week when they finally got down to zero (note: a startup called Robin Hood was the first to announce $0 commission rates a few years ago but it wasn’t until the past couple of weeks that the large incumbents jumped in the mix).
To be fair, this consistent drop in costs wasn’t just altruism on the part of Schwab and their competitors…the advent of online trading had a lot to do with the dramatic expense reduction as it ultimately eliminated the costly necessity of clients calling in trades. You would think with the commission rate of the average trade falling so dramatically, it would have been devastating to the profitability of the discount brokers…but you would actually be wrong. Here’s a chart of Schwab’s company stock performance over the past 30 years overlaid with the average commission their clients paid for a stock trade:
So what happened? It’s simple…the discount brokerages like Schwab saw this day coming many years in advance and started preparing for it. In doing so, they created several new lines of business for themselves, the largest of which for Schwab is banking. If you understand their banking and cash management practices, then you understand why your trades aren’t really quite as “free” as you may be led to believe. Here is how it works:
When you keep an account there, Schwab puts your uninvested cash into a sweep account rather than a money market fund. This might seem like a meaningless difference…I can assure you it’s anything but that. In the sweep account, Schwab gets to decide the interest rate that is paid on that money and it gets to pocket the difference between that rate and whatever the rate is that Schwab is actually earning on it (i.e. market rates).
Here is an easy example:
You have $50,000 of uninvested cash sitting in a Schwab brokerage account. On that balance, Schwab currently pays you 0.35% in their cash sweep program, netting you $175 per year in interest. If that money sat in an equivalent money market fund, it would earn more like 1.75% or $875 per year.
That $700 difference is the cost you pay for free trading.
Some investors rightfully pay attention to this and move their cash to the highest quality and highest yielding options available. A woefully larger number of their clients (representing combined balances greater than $200 billion as of Schwab’s last quarterly filing!) are still keeping balances in the cash sweep program, however, as many investors are either too enticed by the idea of “free” to do their homework or just don’t realize what “free” really costs them each month.
As we always preach around here, be aware of your costs and always read the fine print…there’s a reason they make it so small.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The hypothetical example above is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.