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Zero-Commission Trading: Risks and Opportunities, Part 1

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Part 1: What It All Means for Investors: Online brokers as investments.

Editor's Note: After this article was published, Charles Schwab announced plans to acquire TD Ameritrade.

There's a financial war going on, and the fallout is causing tremors well beyond Wall Street. Investors armed with the right information can make the new zero-commissions standard work to their advantage.

One of the granddaddies of the stock brokerage world, Charles Schwab, recently detonated a financial bomb. On October 1, Schwab announced it would cut its commissions on stock and ETF trades to zero, the first major firm to do so.

"In October, Schwab saw 142,000 new accounts opened, a 31% increase over September."

Smaller, more nimble entrants into the online brokerage space already offer similar services. Their investing tools on smartphone apps help manage portfolios with just a few clicks. Access to stocks, bonds, ETFs and options has become cheaper and easier than ever.

It's an industry that's in massive disruption mode, meaning risks as well as opportunities are rising to the surface.

Investors are now wondering if this should be seen as a "buy alert" for some of those brokerage firms. One thing is certain, this will lead to fresh new prospects if you understand the implications.

We're here to dig deeper and answer these pressing questions for you.

Understanding the New Online Brokerage Landscape

Despite the fanfare, Schwab was not the first to cut rates to zero; Robinhood brokerage has offered free trades on its mobile app since 2014.

But in late September, Interactive Brokers introduced its IBKR Lite platform, offering commission-free trades on US-listed stocks and ETFs.

That's when Schwab threw in the towel and did likewise. The floodgates opened, and several other major online brokers, including Fidelity, Vanguard, E*Trade, TD Ameritrade, TradeStation and Ally Invest quickly joined in.

So how can Schwab and its competitors go from charging commissions to free trading overnight, and stay in business?

In the aftermath of this wave to zero-commissions, the stocks of public online brokers immediately sold off by 10% or worse. In effect, investors and analysts alike suddenly realized a good chunk of broker revenues had vanished, at least for awhile.

SIDENOTE: The truth is, commissions are just one component of revenues. Besides, not all commissions are actually going to zero for all trades and for all brokerage firms. Many will continue to charge fees for trading options, Canadian and other foreign securities, over-the-counter (OTC) securities and penny stocks.

Schwab, with an estimated $3 trillion in client assets, previously earned almost 60% of its revenues just from managing cash.

When an account holds an unused cash balance, some brokerage firms will pay interest. But the rate they pay is typically below what they earn from the bank, allowing them to pocket the "spread." It's a huge source of income.

Zero-commission has become the new standard. And yet within just one month, some of those publicly traded brokerages saw their stock prices recover nearly all those losses and even surpass them, while others have only recuperated modestly.

Why is that? It's likely for a variety of reasons.

Many expect these firms to find new ways of replacing that lost revenue stream. And perhaps those that haven't recovered as well could be seen as eventual takeover or merger targets as the industry moves into a consolidation phase.

It's also worth considering that some brokers pay no interest at all on idle cash balances, potentially pocketing all the yield for themselves. They also earn interest by lending securities to short sellers and on margin loans.

Another way to replace lost revenue may be to route orders through market makers who will pay for the order flow. Smaller firms tend to direct their orders to larger firms to be bundled with other orders for execution, since they're unable to handle higher volumes.

However, this can lead to conflicts of interest, as the market maker or exchange stands to profit from handling larger trade flows. And so brokers are obliged by the SEC to inform clients if they follow this practice.

Consolidation Wave Creates Opportunities

There are essentially four firms that trade publicly in the U.S., and whose main business is securities brokerage. Here's what research firms think of their prospects as they face the implications of zero-commission trading in the future.

The Charles Schwab Corporation (NYSE:SCHW) is a $57 billion company with deep roots that go back to the early 1970s. After announcing zero-commission trading, the stock dropped 16% within a matter of days. But SCHW has since recovered all of that fall and even surpassed its pre-drop level, as the market realizes the loss of commission income is relatively small. The company also earns revenues from asset management, and subscription-based advice and automated portfolio management. In October, Schwab saw 142,000 new accounts opened, a 31% increase over September. CFRA and Argus Research rate Schwab a Buy, while Credit Suisse rates it an Outperform.

E*TRADE Financial Corporation (Nasdaq:ETFC) is a $10.17 billion entity. ETFC dropped almost 20% within days of Schwab's announcement, but has recovered all of that drop and more. CFRA research rates E*TRADE a Buy.

TD Ameritrade Holding Corporation (Nasdaq:AMTD) sports a $22 billion market cap. Its shares lost the most, almost 30%, within three days of Schwab's news. Shares have clawed back by a little more than half since then, which also suggests a longer haul to build back lost revenues. Credit Suisse rates TD Ameritrade as Neutral. Charles Schwab has announced plans to acquire TD Ameritrade.

Interactive Brokers Group, Inc. (Nasdaq:IBKR) currently sports a $19.4 billion market cap. Its reaction was somewhat different from that of its peers. After an initial 13% drop over three days, IBKR shares have moved sideways, just consolidating so far. Interactive Brokers is rated a Hold by CFRA.

Investors Win Online Brokerage Wars

The bottom line is the new landscape in the brokerage sector has suddenly become leaner. The clear winner overall is the account holder, as fees for trading should drop across the board.

Depending on their business models, some brokerages will now have to scramble to replace lost revenues. A few are better positioned to weather this storm, while others will likely be forced to merge or get swallowed up in a round of consolidation. Some of the larger banks, which also offer online brokerage accounts, could become the acquirers.

In Part II of this series we're going to look in more depth at what kinds of investment benefits, and risks, the zero-commission wave presents. We'll also tell you which brokers make the most sense for you, whether you're an American or Canadian investor, and depending what investment tools you need and which markets you want to trade.

Be Sure to Check out Part Two of Our Online Broker Series

Who Should Be Your Broker: Exploring which broker may be right for you.
Zero-Commission Trading: Risks and Opportunities, Part 2

Investors armed with the right information can make the new zero-commissions standard work to their advantage. It's just a matter of understanding what kind of investor you are.

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Disclosure:
1) Peter Krauth compiled this article for Streetwise Reports LLC and provides services to Streetwise Reports as an independent contractor. He or members of his household own securities of the following companies mentioned in the article: None. He or members of his household are paid by the following companies mentioned in this article: None.
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