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How free trading threatens the RIA business model

As brokerages stop charging commissions, financial advice looks like a logical new source of revenue.

With Fidelity Investments jumping on board Thursday as the fourth major discount brokerage firm to eliminate commissions for most online trades, the new game for brokerages officially centers on net interest income, or so the firms are suggesting.

At first blush, it’s easy to follow the argument that the discount brokerage business is now openly pursuing an ultimate goal of gaining scale and making money like a bank.

“If you look at Fidelity and its closest competitors in the discount brokerage space, they all derive the majority of revenues from the net spread between the interest they pay on assets and the interest income on those assets,” said Cathy Seifert, an equity analyst covering the brokerage industry at CFRA.

While the lost trading revenue will hurt some brokerages more than others, it’s true that they are all adept at making the most of idle cash accounts.

However, a more critical or perhaps cynical view might focus on where these brokerage behemoths see real opportunity, in the form of providing more financial advice and services to the millions of individual investors already on their platforms.

“The brokerage space is looking like a freemium model where you get services at a premium that can be added onto, such as financial planning, robo-advice or a full-service adviser,” said Alois Pirker, research director at Aite Group.

“They already have so much assets under management that providing advice is just the next step,” Mr. Pirker said.

Lucille Mayer, chief operating officer at Apex Clearing, agreed that no one should assume zero commissions are anything but the latest step in the industry’s evolution.

“Brokerage firms will be trying to make up the revenue shortfall in two primary ways,” she said. “The first is by layering in restrictions on zero commission accounts, like minimum cash and asset requirements or using proprietary funds.

“The other is by expanding the range of new services that will help create stickiness and loyalty in a client relationship while further monetizing it,” Ms. Mayer continued. “Some examples might include futures, cryptocurrencies, non-purpose loans and securities lending.”

Ms. Seifert also expects the discount brokers to dig deeper into the pockets of financial advisers by offering more consumer-targeted services that compete with those offered by advisers.

“What these competitive pressures mean is that consumers will pay zero commissions, but they might pay more fees for human interaction,” she said. “Longer term, I suspect that’s what many of these firms will do to offset commission-revenue losses.

“They already have some tiered service levels, but we might start seeing a greater use of that with something like a personal adviser as opposed to a call center, depending on your assets,” Ms. Seifert added.

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Fidelity, the largest online brokerage firm with 21.8 million accounts, announced its new trading commission policy Thursday, more than a week after nearly simultaneous announcements by rivals Charles Schwab Corp., TD Ameritrade Holding Corp., and ETrade Financial Corp.

Fidelity’s decision to join the commission-free trend was widely anticipated by industry analysts and financial advisers as they pondered the shifting dynamics along the financial services industry food chain, which includes the asset custody business.

The latest shifts in the landscape have restarted conversations about the relationship between financial advisers and custodians, which often provide services for free when advisers reach certain asset thresholds.

“The custody situation is another plate that’s spinning over there,” Ms. Seifert said. “There’s competitive pressures in the custody business because they’re looking to do more than just back-office services.”

Mr. Pirker thinks changes at the custodian level are inevitable.

“When you look at custody fees, they’ve gone in parallel with trading fees, and it’s no surprise that the online brokerage powerhouses are also the custody powerhouses,” he said.

It’s not yet clear exactly where the biggest players in the discount brokerage and custody businesses are heading, but it’s a safe bet that zero commissions are just the beginning of the changes.

“For custodians, the whole big question is where will they get revenues from RIAs?” Mr. Pirker said. “Advisers need to start thinking about the services your clients want to pay for, because the brokerages are already thinking about strategic directions to move their business models and services in order to align with revenue streams.”