Land of the Free

Over the last week (first week October 2019), all of largest US stock brokers have cut the costs to trade US stocks and ETFs to 0 (yes, zero). It was really just a matter of time.

Starting with Interactive Brokers, then Charles Schwab, TD Ameritrade, and more recently, E*TRADE have all announced this over the last few days. It leaves only the fifth biggest, Fidelity to bring their trading commissions down to 0.

Most observers from outside the digital brokerage space are amazed. The stock market wasn’t very forgiving either; with some of these companies’ publicly listed stocks down 20% over the last few days.

For those on the inside, or those trading with commission free platforms, it was inevitable. While the US has had low cost brokerage for a very long time, this week’s moves was the last domino to fall.

Robinhood, a VC funded brokerage has grown significantly and proven that you can make it work. Having started with a $0 price point in 2013, the business has become a magnet for younger investors starting out in the market and has been able to take advantage of the deep pockets of its funders and the market structure afforded to them in the US.

If you have a quick glance of this market structure in the US, it paints a pretty simple picture — The money in brokerage is not made in brokerage. For years, execution only platforms in the US have been making significant revenue on the “back-side” of a trade.

How zero happens

This structure of the US is totally unique to the US and not really replicated anywhere else in the world. It means that the phenomenon of zero-commission brokers will predominantly be isolated to trading in US equities only.

If you look a bit deeper at these companies and the structure of the US market, you’ll quickly realise that trading revenues make up a small proportion of their revenues. As a guide, it is estimated that Schwab makes only 7% of its revenue on trading, while E*TRADE, which is more focused on execution is closer to 20%. The price issue is therefore far greater for E*TRADE than it is for Schwab.

The Maverick within

When you look at the market in the US, you can get a fair picture of how costs get so low. It’s important to start with the players and customers.

Firstly, there is no one dominant broker in the US like there is in other markets. In the US there are 4 (some would argue 5) major players.

In the UK (Hargreaves Lansdown), Australia (Commsec) and Canada (TD Waterhouse) each have ~45% market share for self-directed investors. They “own” the market and have no realistic pressure coming from other competitors.

Within the US, not only do the main players compete with one another, there is a very vibrant investing market. The general public is engaged with the market, with an estimated 50% of adults having a brokerage account. In Australia, that number is closer to 10%.

In the US, the population see the market as a source of wealth creation, a chance to be part of great businesses taking risk, and they “speculate to accumulate” which is worn as a badge of honour. All three make up what I call the Maverick attitude. I love it!

In Australia (where I’m from) it’s a lot more about bricks and mortar. Property is the dream. Investing is unfortunately more niche and it means that consumers in the space are price takers.

Exchanges equals rebates

Who would have thought Kansas City had a stock exchange….aka BATS. What about the PICO (Pacific Exchange out of San Fran). These are 2 of the 13 stock exchanges in the US.

The multiple exchanges are competing for investors order flow, which ultimately drives more revenue to exchanges via trade fees, data, collateral etc. To do this, exchanges pay market making / execution firms to trade on them.

These rebates then gets passed on to the broker who “sells” their flow to the market makers (Citadel, DRW, GetCo etc) who ultimately execute on the exchange for a rebate or trade against the flow for profit. Brokers selling their order flow and getting paid for (aka Payment for Order Flow) is a well known and some would argue, well accepted.

With Regulation NMS (think “best execution”) in force, brokers are obligated to make sure their customers get the best price for their orders (a good thing), but it means for a broker, it’s just easier to pass through your trade to a market maker to meet that obligation and get paid for it. It’s lucrative too, with market makers and big brokers making hundreds of million each year on the practice.

With monopoly exchanges in Australia (ASX), Hong Kong (HKSE) and the UK (LSE) no such dynamic exists. Similarly payment for order flow is actually banned in Europe…so that ain’t happening over there.

Interest is interesting

Quite simply, brokers around the world make money on idle cash sitting on accounts. This is not unusual and common in all markets. With old established businesses, these brokers have generated huge FUM (funds under management) and a huge proportion of their revenues are generated on the gap between what they pay customers and keep for themselves.

Even in 2019 with rates nearing record lows globally, it’s estimated that 62% of Schwab’s revenue came from net interest margin, which means its in the multiple billions of dollars. That’s one hell of a business when rates move back up!

You see exactly the same in the UK, Australia and all around the world. Scale matters. It gives you a massive head start and cash to rely on. This means the move to zero changes the landscape for both the customer and any future players in the space.

Other services

Digital brokers are much more than just execution. Selling services ancillary to execution is a classic of established players.

Commission free trading needs everything that ‘paid for’ trading needs. Data, research, service and support. Each of these is charged onto the customer. Quality data in the US can be expensive and is charged back to the customer.

Interactive Brokers is offering free data in its 0 commission plan, but it’s IEX data…which only covers 2% of the market. You’ll be trading with your hands behind your back only seeing 2% of the market and you’d probably rather pay for trades and get a better trading result — that is, you’ll lose more on your trade than you saved on brokerage. They know this too, so will offer you marked up data, research and when you are inside the platform and limited by the base package.

What does it all mean.

For those inside the US, trading has always been relatively affordable. Now it’s free. Everywhere. For those outside the US and trading in their local markets, not much will change, all for the reasons set out above. It does mean that there will be more incentive to trade into the US from outside the US.

As the CEO of Stake, a digital-first commission free brokerage for US shares, we’ve seen that first hand. With 77% of our customers having traded before, only a quarter had bought or sold US shares before trading on our platform. What this shows is that the barrier to trading in the world’s biggest and most dynamic market is access not appetite; and that’s why we exist.

So for the mavericks out there, things keep getting better, as they always do — more opportunities, with less friction and less cost. Happy trading as we like to say.

Matt.

About Matt

Matt, originally trained as a lawyer, made his way into the markets at high frequency trading firm Optiver, where he was both a trader and a senior partner. Matt ran Index Trading for Optiver in their US office and ran both their Equities and Institutional Trading desks in Sydney.

In 2017, Matt founded Stake. Stake is a purely digital brokerage offering commission-free trading on US Stocks and ETFs, the first of its kind in Australia. Through Stake’s global expansion, Matt is empowering people around the world trade up to the biggest and most dynamic market on the planet with high simplicity and low cost.

About Stake

Stake (hellostake.com) is a fully digital stock broker that gives investors direct access to the US share market, commission free. Regulated in the UK and Australia, Stake has over 50,000 customers trading up to the US market., Having cut down the barriers for those outside the US to trade in over 3,500 US stocks and ETFs. Stake’s mission is to make it simpler, cheaper, and faster to access the world’s largest share market. With Stake, you can sign up, get verified and be in the market in under 5 minutes. Available on the web, the Apple App store and Google Play.