Free? There Is No Free Lunch

Robinhood is putting pressure on the big boys.  Zero commissions on trading is starting to disrupt their business models. I realize that “free commissions” means that I am getting a really crappy price for my trade compared to the price I might get if I paid a commission.  But, most people probably don’t realize that.  The brokerage takes your order and automatically shuttles it to a dark pool where a high-frequency trading shop makes risk free profit off of it.  It bugs the pros like me that this happens but we are in the small minority.  The general public doesn’t care. So they lost a few cents on a transaction. They don’t make that many of them and if they are in a buy and hold strategy does losing a few cents make a difference in the long run?

What’s TD, Schwab and the rest of the incumbents going to do?  Commissions are 14% of TD’s top-line revenue and they are 7% at Schwab.  They aren’t going to roll over and play dead.  It’s too late to regulate the competition out of existence and it’s too late to “sue the bastards” so they will have to compete and innovate.

1.  Consolidate operations.  Getting big and spreading costs over a larger footprint can protect margins.  A back office is a back office is a back office.  As a customer, do you care?  You just want to know your money is safe and it’s easy to get what you need out.  Interestingly, this allows room for boutique shops to set up and fill the cracks left by consolidation.
2.  Automate.  There will be more automation in all processes.  This is tough in the brokerage business because people are inherently a bit fearful about money.  With the rising incidence of phishing and wire fraud the stakes are higher.  Interestingly, that will make differentiation of the brokerage business even harder.  What is the core difference between Schwab, Fidelity, TD Ameritrade and eTrade?
3.  Cut unnecessary staff and branches.  This ties into automation.  How many people need to walk into a brokerage branch?  About the same that actually needs a bank branch.
4.  Get into new lines of business like wealth management, insurance, and banking.  The lines between traditional banking, insurance, and brokerage will blur further than they are today.
5.  Feature the hell out of their platforms.  Ever go onto TD Ameritrade’s Think or Swim platform and look at the resources to do your own technical analysis?
6.  They will have to figure out the pain points for smaller investors and bring them into the fold.  Education.  I predict it starts with teaching them to save money.  You have to build wealth to manage wealth and our public school system does not teach anyone how to really manage what they make.  It makes sense for employers to take an interest in education to have a happier and stickier workforce.
7.  Create new products that are not plain vanilla ETFs.  Halo Investing is on to something here.

One interesting thing that might happen is this.  Because they no longer make money off of trading commission, they might educate customers to follow Eugene Fama’s Efficient Market Hypothesis style of investing.  Businesses that are built on the idea that zero commissions will encourage customers to trade more might actually die if they are one-trick ponies.  Once a customer has built some savings and wealth, they can make money off of it.  The churn and burn, I have a hot stock, type of investing could become even more of a minority in the stock market.

One other thing to watch is what I call the “industrial marketplace”.  Can the industry educate people enough that they might participate in professional type instruments like options and futures?  Tastytrade is working on this, and CME is listing “micro futures” to try and attract business.  On the Limit Up podcast I started with TopStep Trader, we will be talking about some of this in the near future.

The whole “money” industry is funny.  I remember years ago my friend Dan Dicker who was a member at the NYMEX talked to me about his conversation with JP Morgan.  You can assume that this conversation would have happened at any of the big shops like Goldman or Morgan Stanley as well.  On the IPO, Dan made a little money.  He walked in and asked for “private banking services”.  The banker shifted behind his desk and explained that the kinds of services Dan was inquiring about were only available to accounts of $100MM or more.  Dan asked, “How many accounts are there like that?”  The banker said enough to keep all the banks in business.  At the time, Dan started a business to figure out a way around that hurdle.

A corollary: Capitalism is great. It builds a lot of wealth and there are more millionaires in the US than people realize.  $14 Trillion is going to pass from baby boomers to the next generation.  Remember, a large percentage of baby boomer’s parents were Depression-era people with WW2 coming on the back of it.  Tough times.  The wealth was largely created from 1950 until today.

Interestingly, the discount brokerage industry manages $6 Trillion in client money today.  Places where we traditionally thought wealth management took place like Bank of America and Morgan Stanley manage a combined $5.5 Trillion.

The hard thing in this business is customer acquisition (CAC) which is why you see so many ads for it.  It’s expensive to acquire customers.  This is one reason why robo-advisers like Wealthfront don’t make money.  CAC>LTV at this point.  Entrepreneurs often screw up the math on both sides of this equation.  Can you imagine being in a business where every time you add a customer, you lose money?

Zero commissions are going to have big aftershocks in the brokerage world.  Just having zero commissions won’t be enough to keep customers on the platform. Now it’s gonna get harder to build a business.  The end result for consumers is better service and lower prices.