With zero fees, Schwab risks blowing up brokerage model it built

[NEW YORK] Not too long ago, Charles Schwab Corp helped to usher in the golden age of low-cost, online stock trading.

Now, the brokerage may help to kill off the fee-based business model altogether.

On Tuesday, Schwab said it will eliminate trading commissions on all US stocks and exchange traded funds. The announcement - which was quickly matched by rival TD Ameritrade Holding Corp after markets closed - sent shock waves across Wall Street. Shares of E*Trade Financial Corp slumped 16 per cent, while TD Ameritrade lost more than a quarter of its stock market value. Schwab's share price also took a hit, tumbling nearly 10 per cent.

The gambit is just the latest in an intensifying, industry-wide war over fees for everything from stock trades to index funds and financial advice. And it's squeezing not only the likes of Schwab, but also BlackRock Inc and Fidelity Investments. These types of aggressive price cuts - admittedly a small boon for ordinary Americans routinely nickel-and-dimed by financial firms - have some observers wondering whether anyone can win in a business where more and more services are handed out for free.

For Schwab, it's a bold, but risky move. The firm, which relies less on trading commissions than its competitors, is betting it can offset any decline of revenue by attracting more clients. It can then use their assets to generate interest income, an essential feature of its business that's come under pressure recently as interest rates have declined.

"Maybe because of the inception and growth spurt of online brokers during the dot-com boom, there's a romanticisation of the individual trader," said Michael Wong, an analyst at Morningstar Inc. "There's still a mindset among the investing public around the importance of commissions," which is less important to Schwab.

While trading costs have declined across the board, Schwab comes from a position of relative strength. The firm takes in just 7 per cent of its net revenue from commissions. That's far less than Interactive Brokers Group Inc or TD Ameritrade, which both collect more than a third from trading fees.

Schwab estimated it could lose up to US$400 million in revenue a year from its zero-fee offering. Mr Wong said that in the current rate environment, the firm would need roughly US$20 billion or more in new deposits to offset that loss. Currently, over half of Schwab's net revenue comes from interest earned on its assets. The firm, which oversaw US$3.72 trillion as at Aug 31, took in almost US$20 billion in net new assets that month.

Schwab last cut its trading commissions in February 2017, when it reduced them to US$4.95 per trade from US$6.95 to match Fidelity. Since then, assets at the firm have grown by about US$800 billion from a combination of market gains and net new inflows.

Nevertheless, the company is looking for ways to reduce costs internally. Last month, Schwab said it would cut 600 jobs, or about 3 per cent of its workforce, because of the "increasingly challenging economic environment".

Its latest move builds on an increasingly aggressive, slash-and-burn approach to price reductions. Late Tuesday, TD Ameritrade said it would match Schwab's no-fee trading offer at a cost of as much as US$240 million a quarter, or roughly 16 per cent of its net revenue. Interactive Brokers announced just last week that it would provide free trades. And in recent months, Fidelity, Vanguard Group and JPMorgan Chase & Co have all taken steps to eliminate fees and commissions on some offerings.

According to Schwab chief financial officer Peter Crawford, zero commissions are an inevitable industry trend. Schwab is just trying to get ahead of that.

"We are seeing new firms trying to enter our market - using zero or low equity commissions as a lever," Mr Crawford wrote. "We're not feeling competitive pressure from these firms... yet. But we don't 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. It has seemed inevitable that commissions would head towards zero, so why wait?"

The developments show just how online stock trading is becoming a commoditised business. As a result, Devin Ryan, an analyst at JMP Securities, says brokerages will need to use their platforms to generate revenue from other services. Those include securities lending, charging asset managers fees to offer their funds, and advisory services.

"They have to give a lot away for free to charge for parts of their platform that are less commoditised," Mr Ryan said. Firms like TD Ameritrade might start charging subscription fees for access to data, options and margin accounts.

It's not just brokerages that are facing pressure to cut prices. Fund managers like BlackRock, Vanguard and State Street Corp have also been forced to reduce the fees they charge, particularly for index-tracking funds.

Schwab's announcement carried echoes of the ripple effects of Fidelity's decision to offer several free index mutual funds last year. The day Fidelity made that announcement, shares of other asset managers took a hit.

While the splashy introduction of a free product may attract a lot of customer attention, it could also backfire, according to Dan Ariely, a behavioural economics professor at Duke University.

"The odds are that what people will do is to say, 'Schwab is offering these services for free, and so they can offer everything for free'," he said. The risk is that "when Schwab tries to get these same consumers to do something that costs money, they may say, 'No thanks'."

BLOOMBERG