It's been a wild couple of weeks for customers of discount online brokers. Charles SchwabTD AmeritradeE*TRADE, and Ally Invest all cut equity commissions to zero the week of October 1st, 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.

The industry has been taking baby steps in that direction for several years. Major online brokers started offering a select list, averaging 50-100, of exchange-traded funds (ETFs) for no commission back in 2010. In early 2017, Schwab set off a round of commission cuts that re-set the industry-wide base commission rate at $4.95-$6.95, slashing fees from $7.95-$9.95. The major brokers enhanced their commission-free ETF offerings in the wake of those cuts.

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.

Free Commissions Doesn't Mean Everything is Free

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.

Jennifer Butler, director of asset management and broker research at Corporate Insight, says, "A lot of this movement is geared towards inactive traders, but I don't think they'll make up the revenue by opening new accounts." She believes that brokers are moving further into providing advice in order to function in an environment free of commissions on stocks and exchange-traded funds (ETFs). When analyzing the robo-advisor offerings available for our 2019 Robo-Advisor Awards, online brokers that also offer managed accounts pushed their customers, often not very subtly, into those products.

What about Cash?

A large percentage of revenue comes from idle cash. If new clients are drawn in by the idea of paying no commission on equity trades, they'll bring some cash along. Brokers and clearing firms earn interest on idle cash. Some share that interest with the clients, but quite a few keep the majority of interest revenue to themselves.

Although the stock market reacted quickly to Schwab's commission cut by driving the stock price of all online brokers lower, a look at their financial statements shows that the firm is not dependent on revenue from trading. According to Schwab's filings with the SEC, nearly three-quarters of Schwab's revenue comes from interest revenue, and only 6% was generated by commissions for the three months ending March 2019.

Cash Sweeps

Most brokers offer some kind of cash sweep program, by transferring money at the end of the day into a high-interest account. For some brokers, this action is automatic. When Fidelity announced its commission cuts, it made a point of talking about the practice of sweeping investors’ cash into higher-yielding alternatives without any minimum requirements. "Cash investments at Fidelity could earn 158x more than TD Ameritrade and E*Trade, and 13x more than Charles Schwab cash sweeps," the firm says in a press release announcing the commission changes. A footnote describing Fidelity's cash sweep says, "When you open a new retail Fidelity Brokerage Account, we automatically put your uninvested cash into the Fidelity Government Money Market Fund with a seven-day yield of 1.58% as of 10/8/2019 (unless you choose another cash option)."

On the same date, the Schwab One interest rate was 0.12%, the TD Ameritrade default sweep was 0.01%, and the E*TRADE default sweep was 0.01%.

A Schwab spokesperson responded, "It’s our philosophy that the cash in sweep accounts should be for everyday use, like a checking account, and the rate we pay reflects that. Long-term cash should be invested in a higher-yielding option, of which we have many." Schwab clients have to opt-in to a higher-yielding option, rather than the automatic sweep into a money market fund offered by Fidelity. However, Schwab claims, "Schwab’s bank sweep provides FDIC insurance while Fidelity’s sweep money market fund does not." As it turns out, this claim is true.

How do Brokers Make Money Without Equity and Options Base Commissions?

Revenue streams for online brokers come from a variety of sources, including interest on clients' cash balances as discussed above, but also from stock loan programs, commissions on other products, management fees on advised accounts, and of course, payment for order flow.

Several brokers, including Interactive Brokers, TradeStation, Ally Invest, Fidelity and E*TRADE, share the revenue they generate with the clients who hold the stock that is lent out in their stock loan programs. TD Ameritrade, Vanguard, Merrill Edge and Robinhood do not.

Commissions are not going away entirely. Brokers are still charging a $0.50-$0.65, on average, per contract. Eliminating the per-leg commissions of $4.95-$6.95 saves a lot of money for spread traders, who typically trade multi-leg options strategies. Ally Invest, TD Ameritrade and E*TRADE will continue to charge their base commission to trade penny stocks (OTCBB). Certain mutual fund transactions incur a fee, and there are still commissions charged for bond transactions and trades made with the help of a live broker.

Payment for Order Flow

Payment for order flow continues to generate revenue for most brokers. Some brokers like Robinhood make a major fraction of their income through this practice. Brokers who route orders to generate payment for order flow typically aren't looking for the best price. Robinhood offered free trading at the start because it thought it could offset lost commission revenue with payment for order flow once it had a substantial base of customers placing trades.

Under SEC Rule 606, broker-dealers routing orders on behalf of customers are required to publish quarterly reports that list the venues used for customer orders. You can find these reports on broker's sites under the heading Rule 606 Reports, though they're not easy reading. You can also request a report specifying where your own orders were routed for the previous six months from your broker.

Who still charges commissions?

Some brokers continue to charge commissions for equity and options trades, including Vanguard. Merrill Edge clients who do not qualify for parent Bank of America's loyalty programs also pay commissions, which were cut late in the price wars of October 2019. Vanguard points out that you can trade approximately 1800 ETFs online without a commission, and industry observers estimate that those trades are the overwhelming majority made by their customers.

As of October 21, Merrill Edge offers unlimited no-fee trades per month for customers who have a significant relationship with the broker or its parent firm, Bank of America. Approximately 87 percent of equity trades on the Merrill Edge Self-Directed platform were commission-free. Merrill Edge also eliminated the per-leg commission for options transactions, and cut commissions for clients who are not members of a loyalty program to $2.95 from $6.95.

Who wins and who loses?

Cutting commissions for trading will help clients of online brokers by reducing their trading fees. Brokers with large banking operations, such as Schwab, are likely to come out winners, as are brokers who can convince their clients to consolidate their assets under a single roof. Corporate Insight's Butler sees a move to loyalty-based or tiered benefits in order to encourage clients to consolidate their assets, seeing an uptick in offerings where the more money you bring in, the better rewards you get.

TD Ameritrade and E*TRADE rely the most on commission revenue of the publicly traded firms. For the six months ending June 30, 2019, TD Ameritrade's revenue from commissions was 32% of its net, while E*TRADE's logged in at nearly 18%. Will there be a takeover or merger? Several industry analysts believe so but did not want to be quoted...yet.

While some believe that Robinhood's zero-commission platform inspired these moves, that doesn't explain why the response from the large brokers took five years from that firm's launch. Robinhood woke the big brokers up to the idea that newcomers to trading don't want to pay commissions.

Charles Schwab, the founder and Chair of his eponymous firm said his company made the move now, but was always headed that direction because, as he told Investopedia, "I wanted to take commissions out of the formula. It gets in the way of good investment performance."

What Should You Do?

How should you respond to these commission cuts? If your broker has cut equity rates to zero, take a look at your portfolio and consider harvesting tax losses. Make sure your portfolio is balanced appropriately across asset classes and geographical locations using an asset allocation tool. Those trades can now be made without the friction of a commission charge, which can only help your returns going forward.