There's more evolution than revolution in zero commissions

The elimination of commissions on trades was just a matter of time

Oct 5, 2019 @ 6:00 am

By InvestmentNews

Recent moves by Charles Schwab & Co., TD Ameritrade and ETrade to eliminate commissions on stock trades are a milestone to be sure. But in some ways, the switch to zero commissions was inevitable given brokerage firm competition, the changing nature of the retail securities business and the economics of trading.

The road to free commissions began 44 years ago. Before President Gerald Ford Jr. signed the Securities Acts Amendments of 1975 into law, commissions on securities trades were fixed.

[More: Schwab cuts online brokerage fees to zero]

As hard as it might be for today's investors to believe, before that date every brokerage firm in the country charged the same commission for the same transaction, because the law forbade them from charging otherwise. Just as the fare from New York to Los Angeles was the same whether you flew American or TWA, the cost of buying 100 shares of General Electric was the same whether you went to Merrill Lynch or E.F. Hutton.

The "unfixing" of commissions in 1975 not only amped up institutional trading but also spawned a new kind of brokerage firm: the discount broker. By offering trade executions through salaried staff, Charles Schwab was among the first to charge individual investors less.

At first, traditional brokerage firms dismissed discount brokerage as nonsense. (Even then, New Yorkers thought Californians were strange.) After all, stocks were sold, not bought, and only a few kooky customers would buy and sell stocks on their own.

Well, the number of kooks kept growing, and while most investors continued to prefer to buy stocks and mutual funds from someone who would give them advice, the clear price difference between discounters and "full-service" firms eventually eroded what the big firms could charge.

Technology and huge increases in trading volume kept driving down the cost of transactions over the years to the point where today the actual cost of a trade and the attendant post-trade processing and record keeping is probably only a few cents.

[More: TD Ameritrade fires back at Schwab by cutting commissions to zero]

The money to be made in stock trading comes from the float on customer cash that sits around brokerage firms during the settlement process and from custodians' ability to lend out shares parked in customer accounts to institutional investors. Schwab and TD Ameritrade aren't giving up much revenue by offering their customers "free" trades.

For the still relatively tiny segment of the investing public that actively trades, zero commissions are great news. But since active stock trading has little relationship to investing, don't expect free trading to spur a sudden increase in individual retirement account balances, for example.

[More: ETrade follows Schwab, TD, and cuts commissions to zero]

Zero commissions may actually encourage excessive trading, which increases the likelihood of loss. In that sense, free commissions are like free drinks at a casino: a cost-effective way to encourage more gambling.

Over the years, the vast bulk of investors who continued to want advice found that commissions were often a peculiar way to pay for that advice. While securities law enshrines the transaction and makes advice ancillary to it, investors were discovering that as transactions became cheaper, advice about the transaction was more valuable than the transaction itself.

[Recommended video: Why millennial demand for ESG is falling on deaf ears]

That realization, as well as the simple economics of recurrent fees being far more lucrative for securities firms than ever-cheaper episodic commissions, caused brokerage firms to embrace fee-based accounts. It also drove the growth of the RIA business, which left compensated transactions out of the adviser's purview entirely.

While "free" certainly catches people's attention and makes news, the move to no-cost commissions is more of an evolution than a revolution.

Register now for our ESG & Impact Forum at the U.N. on Dec. 5.

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