You may have seen the recent news that major brokerage companies like Fidelity, TD Ameritrade, and Charles Schwab are now executing equity trades with no fees. At first glance, this announcement may seem to be good news, but perhaps with potential caveats.

First, it’s important to note that transaction fees have never been a big cost item for Modera clients, as we avoid excess trading whenever possible and minimize turnover. As a result, the benefit of zero dollar trading fees may not be significant.

Second, brokerage companies are still in business to make money. So, the question is: how will they survive and will costs eventually be transferred to you, the consumer, but in a way that is less transparent?

To help answer the question, let’s provide some context for how brokerage firms earn revenue in the first place.

How brokerage firms earn account revenues

Trading commissions represent an increasingly low percentage of revenue at brokerage firms. Instead, a source of greater potential profitability is “order flow”. When a trade is placed with a broker, an investor expects to receive the best available price. The broker may go directly to the exchange (e.g., NY Stock Exchange, Nasdaq) where the security is traded, or it may use an intermediary trading company to find more favorable pricing for trade execution. Both the exchange and intermediary make money from the gap between the bid (buy) and the ask (sell) price, and some of that profit is rebated to the executing broker.

This practice, while standard in the industry, creates a conflict of interest between the brokerage firm and the investor, as the broker can either keep the money or complete the trade at a more favorable price by passing the rebate back to the investor. This process is broadly known as payment for order flow.

Another area of custodian profitability is “net interest”, or the gap between what a brokerage firm pays an investor for uninvested cash and what it earns on that cash. Net interest is also realized in the form of the interest rate that the firm charges for a margin loan. If an account holder maintains $20,000 of liquidity in a brokerage account, a brokerage firm paying ½% more on uninvested cash delivers $100 more into the investor’s pocket each year. If an investor requires a margin loan of $500,000 for one year, a brokerage firm offering a 1% differential creates $5,000 of additional annual value. As you can see, these numbers can easily dwarf the more broadly publicized savings of zero-dollar commissions.

What does this mean for you?

This is a very fluid situation. Although the “$0 trade commissions” mantra is being marketed by brokerage firms as a clear benefit for consumers, the retail investor needs to be aware that brokers must find new sources of revenue in order to stay in business – and unfortunately, it may not be very apparent where the true costs lay.

The management of custodian relationships, and our conversations with clients, will certainly become more challenging in this environment of “free” trades. On behalf of its clients, Modera carefully monitors underlying brokerage practices that create cost differentiation. We also scrutinize custodian service levels provided to our firm, lest they deteriorate in the face of reduced transaction revenues. Moving forward, we will continue our role as a fiduciary, working in your best interests to assess these industry changes and any potential impact.

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