For online brokers and their customers, 2019 was the year everything changed. While small investors pulled out of the rising markets and sat on their cash, online brokers continued their race to zero commissions. Then Charles Schwab moved to acquire TD Ameritrade.

2020 started with adjusting to the new normal of $0 commissions for equity trades, then volatility and huge market swings returned. Most online brokers have seen a surge in equity trading now that customers don't have to factor commissions into their gains (or losses). And now we dwell inside that proverb, "May you live in interesting times," as we deal with this global crisis. Financial markets have also seen unprecedented change, impacting all investors.

Trading Surges as Markets Plunge

According to Sandler O’Neil, the last 5 trading days of February 2020, as the markets reacted to the threat and then the reality of a coronavirus pandemic, saw more than 10 billion shares traded each day, with February's industry share volume averaged 9.3 billion shares per day -- a 19% increase over January 2020, and a 28% jump since February 2019. Since then, trading activity among individual investors has nearly doubled, according to Fidelity and E*TRADE.

These trading surges affected the performance of several brokers' services. During the week of February 24, the outage tracking website DownDetector reported problems logging in for Charles Schwab, TD Ameritrade, Robinhood, and Vanguard. On March 2, Robinhood suffered a total system failure for the entire trading day. Robinhood outages persisted every trading day through March 16. E*TRADE clients reported login issues near market open for six trading days in March. During trading stops set off by SEC circuit breakers on March 9, March 12, March 16 and March 18, customers at quite a few brokerage sites reported inabilities to trade, and blamed those on their brokers rather than on the exchanges.

Key Takeaways

  • Retail investors pulled assets off the table in spite of an overall rising market during 2019.
  • Commission cuts during the fall of 2019 enticed equity traders back into the markets.
  • Two of the largest online brokers plan to consolidate during 2020.
  • Wild market fluctuations due to the coronavirus scare increased volatility and trading activity.

A Focus on Value, not Costs

Charles Schwab created a flurry of change when it cut its equity commissions to zero in early October 2020. TD Ameritrade, E*TRADE, and Ally Invest quickly followed suit, and Fidelity joined the crowd on October 10th. Bank of America's Merrill Edge extended free trading to all members of its loyalty program on October 21. In early January 2020, Vanguard also cut its equity commissions to zero. All of the brokers we reviewed have pricing plans with $0 commissions for equities. Most charge $0 per leg for options trades as well.

Given the move to zero commissions across the industry, we tightened our focus on the overall value offered by each online broker for this year's reviews. But lost in most of the discussion is that none of the brokers that cut their equity and base options commissions to zero has completely given up all their commission revenue. Brokers still charge per-contract fees for options trades, and also levy charges on futures, forex, bonds, and some mutual fund transactions. There are also a variety of fees typically charged for corporate actions (such as stock splits), sending international wires, and account transfers.

How Brokers Make Money

Brokers need to generate revenue somehow, and one obvious way is to route equity orders to market makers that pay them for the order flow. Payment for order flow is one of the little known practices some online brokers use stay in business. Under this practice, a broker bundles its orders for specific stocks and routes them to a market maker, who pays the broker a fraction of a penny for each share or contract handled. Some brokers can see a boost in their income, but the customer may lose out on a possible price improvement on the order. 

In essence, when choosing how to route an order, a key decision must be made: Generate payment for order flow, or find price improvement for the customer’s order? Brokers can pick just one. We saw a war of words break out between Fidelity and Schwab at the end of October boasting better price improvement or treatment of idle cash than the other after both cut their equity commissions to zero. 

While fees and commissions are visible to customers there are other revenue-generating practices that are not. For each of the brokers we reviewed, we looked at how idle cash is handled, execution quality statistics, stock loan programs, and portfolio margining practices. In ranking our group of online brokers, we took a hard look at how brokers make money from – and for – you.

Staying Alive in a Zero-Commission World

One effect of the cuts in equity commissions was positive for small investors: exchange-traded funds (ETFs) can be traded without fees at most online brokers. By making all stock and ETF transactions commission-free, brokers have eliminated the benefit of offering a list of ETFs to their customers that do not incur transaction fees -- but they have also eliminated the fees that the fund providers had been paying them, erasing another revenue source.

When Schwab led the commission-cutting parade, investors responded by selling off their TD Ameritrade stock since a large percentage of TD’s revenue depended on commissions. In late November, Schwab announced the acquisition of its rival for $26 billion in stock. This acquisition even spawned its own hashtag -- #Schwabitrade – on Twitter.

Industry Consolidation

A big question about the TD Ameritrade acquisition revolves around the concentration of advisor-managed accounts that would be held under the Schwab banner after the deal closes. The two firms serve not only retail investors – they both have services for registered investment advisors who manage clients' assets. This merger would create an advisory behemoth, with almost three-quarters of U.S. assets under management held at a single firm.  

In late January, both Schwab and TD Ameritrade received requests for additional information—commonly referred to as a second request—from the Antitrust Division of the Department of Justice (DOJ) in connection with its review of Schwab’s proposed acquisition of TDA. The second request extends the period of time the government will take to review the deal., and is typical for a deal of this size. Schwab says it intends to cooperate fully with the DOJ and expects its purchase of TD Ameritrade to close in the second half of 2020.

The Morgan Stanley acquisition of E*TRADE also consolidates another large chunk of advisor-managed assets, but it expands Morgan Stanley's retail offerings considerably. This buyout appears to be adding capabilities to what MS offers rather than swallowing up a major competitor with similar services. Jennifer Butler, Director of Asset Management & Brokerage Research at Corporate Insight says, "With its acquisition of E*TRADE, the firm will fill its missing gaps in the retail investing marketplace by opening its doors to the mass market." Butler points out that E*TRADE's stock plan service was a key factor in the acquisition, and that the stock plan participants are an appealing target for cross-selling Morgan Stanley’s wealth management businesses.

Looking Ahead

While we expect more consolidation in the online broker industry, new entrants are testing the marketplace with niche ideas. In mid-2019, the new brokerages that launched, which included dough and TradeZero, opened their virtual doors with $0 commissions prior to Schwab's pricing cuts. Though current industry participants we talked to were not sure that a new entrant to the online brokerage space could find a niche, all agreed that zero commissions for equity trades is the standard going forward.

What will brokers do to generate revenue and stay in business? Lule Demmissie, president of Ally Invest, says, "Many brokerages lost a significant portion of their revenue stream this past year and finding new ways to recoup some of this, while not taking away from anything investors have come to expect will be vital. Banking products and full-scale integration with wealth management will also be very important in the landscape going forward." Brokers that also have an automated investing platform, robo-advisory, or managed accounts have added nudges to encourage their customers to switch to one of those services that generate revenue for them. 

TradeStation's Nick LaMaina, senior vice president of strategic brokerage services, says that "Brokerage customers want ideas and education. We expect TradeStation to continue to focus on these two key areas to fulfill that need." TradeStation acquired education site YouCanTrade in 2019, which offers some free classes but primarily charges for its offerings.

As for the legacy brokers, the big question is how will they stand out from their competitors now that they all look similar when it comes to costs. "The industry will have to compete on client experience," Joseph Barakat of TD Ameritrade states. Barakat believes that his firm's educational offerings will help their clients take advantage of new-to-them asset classes, such as options trading, to enhance returns. Like most other brokers, TD Ameritrade charges a per-contract fee for options trades.

Is there room for New Brokers and New Asset Classes?

In spite of seeing two of the larger brokers get acquired recently, there is still room for new online brokers that focus on strategic niches. There is also room for greater personalization of the online brokerage experience, in which tools and features that a customer uses are featured in a way that makes them easier to find. Services such as TradeIdeas, which has an artificial intelligence engine that can help with trading ideas, can link to partnered brokers' trading engines via API so its users can place trades without leaving their site.

Another idea we are following is the introduction of new products to trade, such as the futures contracts being designed by The Small Exchange. The Small Exchange was formed to create a futures exchange, focused on the retail trader, to allow trading of proprietary products. The five products available, which cover oil, US Dollars, US stocks, 10-year treasury yields, and precious metals, are all described in detail on the exchange's website. It's an innovative and fascinating idea, and one with the potential to introduce a new asset class to retail investors.

One thing we know for sure. Market volatility is back and retail investors will need stable platforms they can trust that also offer education and resources to help us navigate the landmines in the investing terrain. Making sure that all platforms are stable, and run smoothly during market surges is key, as is the ability to find market sectors that aren't floundering during these precipitous drops. A friend of mine quipped during the dot-com crash of the early 2000s, "My 401(k) is now a 201(k)," and moved all his holdings to cash. Any way of keeping customers engaged and hopeful for the future is helpful.