Schwab is cutting commissions to 0%!
Starting on October 7 all U.S. traded ETFs, stocks, and options will trade commission free. Schwab will still charge $0.65 per contract on options trades.
Schwab is a discount broker. Clearly they just erased a large portion of their revenue and profits to remain competitive against the new mobile threats.
Trading revenue accounted for about 8% of Charles Schwab’s revenue. When Schwab announced the new pricing its stock sold off about 8%. But like everything else with the stock market that efficient first move became inefficient as short-term overreactions took hold.
The overreaction stems from the misunderstanding about how Schwab makes their money.
Charles Schwab’s Main Revenue
Schwab is more like a bank then a broker. Over 57% of Schwab’s revenue comes from its net interest margin. The spread between what Schwab pays its customers on its cash versus what Schwab can earn on its investments in 2-year U.S. Treasuries.
The chart below is from Schwab’s 2018 10K and the 40th issue of the AMM Dividend Letter.
Trading commissions have been declining ever since discount brokers came into existence. The internet just accelerated the process.
Because Charles Schwab makes the bulk of their money and profit from the net interest margin they want more accounts and more assets on its platform. Every account has some sort of cash balance. The average across all its accounts is 10+%. Schwab can sweep this cash onto its balance sheet and then invest in U.S. Treasuries to earn interest income.
Unlike standard banks, Schwab can pay far less in interest on its customer’s cash. Customers at Schwab view their cash as strategic cash. They’re willing to earn less in interest because they don’t view their cash balance like they do with a savings account. They want their cash readily available to invest in the next opportunity. Schwab’s cost of funds, what it pays customers to use their cash on its own balance sheet, is very low. In fiscal 2018, Schwab’s cost of funds was 0.27%. Compare that to JP Morgan’s 0.57% fiscal 2018 cost of funds.
Schwab’s focus is asset growth. Being one of the lowest cost online brokers is important to Schwab for its asset growth. Regarding retail investors, every time commissions drop Schwab’s total potential market increases. More importantly, zero commissions are crucial to protecting its RIA custodial business and its RIA asset growth.
RIA growth is one of Schwab’s biggest growth drivers. Asset growth at RIAs is growing over 11% on a compound annual basis. RIA asset growth at Schwab is growing even faster.
Signing up new Independent RIAs on Schwab’s custodial platform can add more assets faster than Schwab can by opening up individual accounts. RIAs want to tell their clients that they are using the lowest cost and highest quality tools in their clients’ accounts. Schwab is the highest quality RIA custodial platform and they now offer the absolute lowest commissions. Schwab’s custodial platform remains one of the most attractive options for independent RIAs.
RIAs should be better at managing their clients’ cash balances. They should be sweeping the majority of unused cash into higher-yielding money market accounts, short-term treasuries, or CDs. The sad truth is a good portion of RIAs are lazy in this regard. They leave client cash in the default cash sweep feature. And even the RIAs that are diligent about managing their clients’ cash, leave 1-2% in cash that can be swept unto Schwab’s balance sheet. Again, more RIA asset growth leads to more cash that Schwab can use to earn interest income.
The loss of trading revenue is a short-term hit. Schwab is more concerned with asset growth. The announcement to cut its commissions to 0% protects its asset growth and protects its larger market opportunities.