Interesting insight into the business of discount brokerages.

February 5, 2021 11:04 AM

How Discount Brokerages Make Money. ".....This is an exaggeration, but not much of one. 57% of Schwab’s revenues are from net interest. The firm could literally give away every other service; discount the mutual fund fees to zero, do away with commissions, etc etc, and they would still be profitable."

"Suppose I were to give you $200 billion dollars. Now I’m the American middle class and you’re Charles Schwab. You would earn something like $5.8 billion dollars in net interest income. This would entirely pay for your sideline business in running a brokerage. Stocks, bonds, mutual funds, branch offices, call centers, blah blah blah, it all exists to justify the only pricing page that matters, and all the verbiage on the pricing page is about how much you pay the customer...."

posted by storybored (25 comments total)

Float, it keeps the world, cough, afloat.
posted by sammyo at 11:08 AM on February 5, 2021 [3 favorites]

The average customer keeps ~10% of their balance as cash? What, why?
posted by explosion at 11:23 AM on February 5, 2021 [1 favorite]

People that think they can time the market?
posted by JoeZydeco at 11:41 AM on February 5, 2021

This is not the correct way to think about the economic profit of a discount broker.
posted by JPD at 11:52 AM on February 5, 2021

"Wall Street makes its money on activity. You make your money on inactivity." -- Warren Buffett

I've heeded this advice for some time now...
posted by jim in austin at 11:57 AM on February 5, 2021 [3 favorites]

The average customer keeps ~10% of their balance as cash? What, why?

Laziness and hedging against potential impulse purchases of investments, I'd expect. If I wanna buy some GME today (I don't), I may not want to deal with transferring money to/from various accounts -- I'd just want to log in, make a buy, and be done with it. I definitely wouldn't want to deal with selling other securities, incurring tax consequences, just to make a "I'm fucking around" purchase. I myself already don't do anything for less than a couple grand because the taxes are just not worth the hassle, what with every Tom, Dick and Harry managing to lose my cost basis every few years when they fuck around with their back-ends.

...now, in my case only my E-Trade account has cash (~3%), but it should probably be zero, but I'm lazy ... so fuck it.

Plus, nowadays, yeah, a lot of people are expecting a crash so I'd expect if they cashed out of something they might leave that cash sitting around for the abovementioned impulse purchasing they think might be coming up in the next year.
posted by aramaic at 11:59 AM on February 5, 2021 [2 favorites]

guYz THis iS somEThinG tHe BLOckcHain WOulD SoLvE !!!!!!
posted by lalochezia at 12:17 PM on February 5, 2021 [3 favorites]

"still be profitable" is not the goal of publicly-owned American corporations. Numbers gotta go up, every quarter, into perpetuity.
posted by meowzilla at 12:25 PM on February 5, 2021 [2 favorites]

The average customer keeps ~10% of their balance as cash? What, why?

You sound like that's shocking, I'm not sure why?
posted by justkevin at 12:54 PM on February 5, 2021 [1 favorite]

lalochezia: guYz THis iS somEThinG tHe BLOckcHain WOulD SoLvE !!!!!!

Maybe a Beowulf cluster of blockchains?
posted by johnabbe at 1:39 PM on February 5, 2021 [2 favorites]

You sound like that's shocking, I'm not sure why?

Because the money I want to stay as cash is already in my checking account. Anything I've put into my investment account, I want invested.

I understand that there will be small bits of my money remaining in "cash" for a day or two as positions change, but if 10% of my cash on average across the year was "not doing work," something is wrong.
posted by explosion at 2:33 PM on February 5, 2021 [1 favorite]

I am surprised at 10 percent as well. When I first bought an index fund, I kept $50 in cash to pay fees, until a few months later I realized the occasional purchases were free. The cash in my account earns pennies per year while my funds earn dollars per month, so I don't keep cash for more than a few days.
posted by soelo at 2:34 PM on February 5, 2021

I am surprised at 10 percent as well
I bet a lot of it is not-yet-reinvested dividends, and cash-equivalent accounts that are part of target-investment plans.
posted by The_Vegetables at 3:13 PM on February 5, 2021 [3 favorites]

I have my mid-five-figures brokerage account mentally earmarked as my "down payment fund", and 50% of it is in cash because I hope to buy my first home within the next 12-18 months. In fact, it's probably time to sell the other half (which is currently in nice boring index funds) as well. I can't be the only person with a short-term horizon who doesn't know where else to put their money, can I?

(Yes, I know, CDs and high-interest savings are at least slightly better than my current cash position - but at current interest rates, the hassle is just not worth the tens of dollars that'd earn me).
posted by mosst at 3:28 PM on February 5, 2021

I assume active traders want the convenience of cash in their brokerage account. A checking account would earn them interest, but at current rates that's not going to be very much.

(I have never been an active trader and have not put money in an individual stock in years)
posted by justkevin at 3:33 PM on February 5, 2021

We have over 200k in cash if you consider money market funds cash. Why? because I have lived long enough to know that there are periods that span years when you don't want to draw down your investments in order to pay living expenses when you are involuntarily unemployed.
posted by Pembquist at 6:01 PM on February 5, 2021 [1 favorite]

This is not the correct way to think about the economic profit of a discount broker.

This is close to your industry. Elaborate, please?

I always assumed they made their money by gouging folks on spreads and markups. Bob the retail client isn’t exactly getting the best execution on trades.
posted by leotrotsky at 6:22 PM on February 5, 2021

This is not the correct way to think about the economic profit of a discount broker.

I don't know why you would say that. You can see the numbers with your own two eyes in Schwab's annual report.

Take note of page 33. For 2019 Schwab made $6.5 billion net interest on cash deposits. This represents 60% of total net revenue. 30% of net revenue comes from mutual fund fees and advisory fees. Only 6% comes from commissions and trading fees.

If you go to page 35 you see that they made about 2.41% interest on $268 billion in deposits, the above mentioned $6.5 billion.

It absolutely is the case that the great majority of annual income comes from client cash deposits.
posted by JackFlash at 9:20 PM on February 5, 2021 [1 favorite]

The numbers are obviously correct, but its a misunderstanding of why people are willing to let Schwab capture those revenues and how Schwab sets their prices. Its easier to price for service through foregone income than it is by increasing the costs of the service. Its a behavioral thing. Discount brokers have brought down the total cost of managing your retirement accounts, but one of the ways they make that delta appear bigger than it is, is by capturing the spread income. They smoked commissions (and other fees) relative to what a wirehouse would have charged you, but drove wrap accounts as a way to generate some revenues off of your excess cash. Net-Net its good for the consumer, but not as good as the nominal delta in the fee reductions imply.

Put another the way - the question isn't "Why does Schwab make so much spread income" but rather "Would Schwab's customers be better off with a solution that swept their cash balance into higher interest rate savings accounts, but then charged them explicitly for the other services Schwab provides them." By charging people through spreads, Schwab makes that harder to figure out. My guess is people would be better off, but there is a lot of inertia in customer relationships and the aforementioned behavioral thing. And the excess profits are going to be much smaller than the excess interest income schwab earns.

If you wanted to do this analysis correctly you could look at Schwab's deposit costs relative to the market and then figure out what revenue/AUM non-discount broker/wrap account platforms generate relative to Schwabs revenue/AUM ex-interest income. Add the deltas of the two up and you have your answer. My guess is Schwab is still cheaper, but not by as much as it cosmetically appears. Vanguard probably not the right bogey on that last bit as Schwab is a higher touch relationship. (you should use Vanguard BTW)

The spread income is just a manifestation of the economic value of the customer relationships Schwab has built and how they've determined what is the best way for them to charge for that.
posted by JPD at 7:41 AM on February 6, 2021 [1 favorite]

BTW - you can find the Schwab Bank financials here: https://cdr.ffiec.gov/Public/ViewFacsimileDirect.aspx?ds=call&idType=fdiccert&id=57450&date=12312020

You can see its an 11.5% Return on Tangible Equity business as compared to 22% for Schwab as a whole. If you figure a bank which is purely a commodity - just taking deposits and buying securities - should be an 8% ROE or less, so you could transform Schwab's bank by saying it made something like 800mil to a 1.2bn dollars more than it should have. (3.5%*22000 mil in equity) And you might attribute that to the customer relationships. Its roughly 90 bucks an account given 14 million accounts. Is the cost saved on the other side of the relationship close to that? IDK - but that's the question

ITs not a very high net interest margin bank either at 1.3% (avg NIM for US banks in 2020 was probably 3%). The returns only are what the returns are because the asset book is such low risk the capital required to be held against it is really low.
posted by JPD at 8:07 AM on February 6, 2021

Well, all of that gobbledygook says nothing different than the original article.

How does Schwab make their money? Not from trading commissions, but from interest on cash in clients accounts.

It's not that complicated.
posted by JackFlash at 8:57 AM on February 6, 2021

And how is this information of value to customers?

Simple. You can use Schwab for free trades but keep your uninvested cash balance low. That's all.
posted by JackFlash at 9:08 AM on February 6, 2021

Well no, but thanks. FTFA

But instead people get mad about payment for order flow, because nobody writes books about Interest Rate Spreads Are Just Too Darn High.

And I explained why taken in isolation that's not a correct statement.
posted by JPD at 9:08 AM on February 6, 2021

How is that statement not correct? It informs customers how Schwab is extracting money from them that they may not be aware of and what they can do about it. Don't keep high cash balances. You are trying to make something complicated that isn't.
posted by JackFlash at 9:22 AM on February 6, 2021 [1 favorite]

You say "the economic value of the customer relationships Schwab has built," I say "value extracted from customers through deliberate opacity of costs." Part of which is this entire approach to obfuscating what is, as JackFlash says, a fairly simple market process, and one a lot easier for ordinary customers to both understand and circumvent than payment for order flow.
posted by praemunire at 11:56 AM on February 6, 2021