Bank of America(BAC)’s announcement today(10/11) that it would offer 30 free trades per month to customers with combined balances of $25,000 or more was greeted by investors in online brokers with a stampede for the exits. E*Trade(ET) and TD Ameritrade(AMTD) were both trading down around 10%, and Charles Schwab(SCHW) was down more than 5%. Bank of America’s announcement comes just days after the launch of Zecco, a new online broker which also offers free commisions. Past attempts at commissionless sites(i.e. freetrade.com) have failed to take market share and have been shut down.
At least for the moment, the market believes this is different. And it is. Bank of America is a behemoth, having relationships with over 50 million American households, 40% of which will already qualify for free trades. ETrade can scarcely afford to eliminate commisions; commision revenue consistently exceeds net income.
So what’s an online broker to do? Relax.
When discount brokers emerged and online stock trading was America’s new national pastime in the late 1990s, it was a widely held belief that full service brokerages would be forced to cut commisions or face the disappearance of their business. Despite the fact that commisions haven’t been cut these companies are at record stock prices and making record profits. Apparently, commision costs aren’t the only factor driving investor behavior. Full service brokerages also began to shift clients towards non-commision based fees, charging many customers a flat percentage of assets.
The market’s reaction is overdone. ETrade, Ameritrade and Schwab already face lower-priced competitors and have continued to grow. For most investors, the difference between $13, $7, and $0 is not sufficient to motivate them to go through the hassle of switching brokers if they are otherwise happy with the service they’re receiving.
Commisions will not disappear overnight. There is a cost to executing trades, and everyone, even Bank of America, needs to pay it. If brokers aren’t making money off commisions, they’ll need to make it up elsewhere. Whether that’s through higher margin interest rates, lower interest paid on cash accounts, or additional fees, remains to be seen. Commisions have been consistently falling for the past 10 years, and online brokers have only become more profitable. Is that a guarantee that continued drops will not reduce profit? No, but Bank of America’s move is the beginning of the end. After all, you can’t get cheaper than free.
Disclosure: I have no positionin BAC, ET, AMTD, or SCHW
Speaking as someone with brokerage experience (3 years in the biz), methinks you could be too sanguine here.
The investors who aren’t motivated to switch are minor contributors to the bottom line. The brokerage business is probably 80/20 or maybe even 90/10… in the sense that 10% of the clients provide 90% of the revenues. The difference in activity levels between the average joe and the market addict are staggering. It’s one thing for a business to lose 10% of its clients, vs seeing that business lose 10% of its most PROFITABLE clients. A lot of times, the most profitable segment is the reason that the doors stay open in the first place. Without them, the whole operation becomes a treadmill.
I would imagine ETrade et al have been able to fend off lower priced competitors up til now because those competitors have mostly stunk. For an active trader / investor, there’s no value in going el cheapo if the service is truly horrible. Transaction costs are everything, but only up to a point. A lot of these third-rate discount houses offering super-low commissions are forced to cut their backoffice staff to the bone, resulting in horrible executions and worse service. That’s not real competition. It’s Yugo competition: yeah the car is incredibly cheap, but the engine has this annoying habit of melting on the highway.
BofA, however, is another story. If they can offer cheap-to-free AND passable service and execution, then the Etrades and Ameritrades could be in deep doodoo as their profit center customers go bye-bye (leaving the headache customers behind).
I’m reminded here of how Circuit City and Best Buy sell CDs at close to cost because they don’t really care about making money on CDs. They just want you in the store more often to tempt you with the big-ticket items. If a BofA or whoever figures out that they can offer cheap-to-free commissions, pair it up with genuinely decent service and execution, and make their profit elsewhere–say, on bundled services and scaled-up float–then all of a sudden Etrade et al starts looking like Tower Records. Or if not Tower Records, maybe Amazon.com… a company that has perpetually burned its investors while showering its customers with largesse.
jest me .02
Also, you said: “There is a cost to executing trades, and everyone, even Bank of America, needs to pay it.”
It sounds crazy, but this isn’t always the case. Brokerage firms can make a lot of money working the bid / ask spread on customer orders… in some cases, they can make more on customer order flow than it costs to execute the transaction. When an investor buys General Electric, he usually doesn’t worry about five cents up or down. But all those pennies add up for a market maker taking the spread behind the scenes, thousands of times per day.
Usually, though, an Etrade or an Ameritrade etc outsources this market-making activity, to a firm like Knight (NITE:AMEX), and splits the profits with them.
This is another area where a BofA has interesting synergy. Because BofA is heavily involved in trading, as most behemoth banks are, they already have the high-end technology and brainpower required to efficiently exploit bid / ask spreads. They don’t need to share market-making profits with an outsider like Knight. Theoretically, if their technology and operations are good enough, an integrated firm like BofA could offer zero commissions to its customers and still make a profit on their executions. Of course, even if BofA merely breaks even–if their market-maker profits net out the transaction cost at zero–the value of the float and bundled services still makes brokerage a compelling proposition for them.
Sorry, NITE is Nasdaq, not Amex. I’ll go away now…