Introduction – Disruption in the industry
The 2010s were a decade of incredible innovation in the financial industry, putting an enormous amount of pressure on the incumbent players and forcing them to make drastic decisions to survive. The securities brokerage industry was hit particularly high, as modern and affordable challengers like Robinhood are eating up more and more market share, especially among the new millennial class of investors. But the reaction made clear that Charles Schwab was not going to go down without a fight and in october it dropped the transactions fees for stocks down to zero, sending shockwaves across the industry. After that, it immediately looked at one of the main competitors TD Ameritrade, now incredibly cheap after a 30% drop in market value, and seized the opportunity to build the scale this businesses desperately need to keep up with investments and exploit network effects.
The Securities Brokering industry serves as an intermediary between investors and investment securities such as stocks, bonds and derivatives. Brokerage firms match a client’s buy order with a third party’s sell order or fulfill the client’s order with their own investment products. The industry generates revenue from trading commissions, which include advisory and portfolio management tools, as well as transaction (now under strong downward pressures) and asset-based fees (for specific more tailored investment product). With the rise of electronic trading and discount brokering, many industry operators have started to offer more value-added services such as investment advice for clients to justify higher fees for the management of the portfolio rather than anachronistically requesting transaction costs. The overall market size in terms of revenues is estimated to be around $160bn, of which about one third is in equities and 25% in debt securities while the rest is split among derivatives, mutual funds and other products.
In this article we are going to focus on the equities market, as it is the most popular for retail investors and most of the new challengers are pushing in the stock and ETF markets the most.
Stock Brokerage houses
There are dozens of stock brokerage houses in the US, but the biggest four, often referred to as the “big four brokerages”, are Fidelity Investments, Charles Schwab, TD Ameritrade, and E*Trade.
The first one in terms of clients assets is Fidelity: with $7.4tn in customers asset Fidelity is the US largest keeper of 401(k) retirement savings plans and the largest provider of 403(b) plans for nonprofits. The company has 27.2m active brokerage accounts and 28m individual investors and offers investments in Fidelity ETFs and mutual funds as well as investments in third-party products. In addition, through its mutual funds and other advisory services, Fidelity has tens of millions of non-brokerage customers.
The second position is held by Charles Schwab which holds $3.25tn in client assets and can count on 12.2m active brokerage accounts. In addition the company allows its brokerage clients to link their trading account with a checking account, as a result it has 1.3m active banking accounts ; moreover with its registered investment advisor accounts, it sits on $1.5tn of AUM. Although it is a brokerage house, only 7% of third-quarter revenue come from trading fees, 60% of revenues come from interest on the group’s active customer accounts (coming from the leverage that investors use on trades) and 30% come from asset management. Charles Schwab ended last year with $10.78bn in revenues and a profit margin of 35.12%. However, the choice of the company at the beginning of October to cut its trading fees to zero is expected to reduce Schwab’s overall revenue by as much as 4% a year, or $400m a year.
The third broker in the US (for now ignoring the acquisition by Charles Schwab) in terms of clients’ assets is TD Ameritrade with $1.3tn in customer assets and 11m client accounts. TD Ameritrade ended last year with $5.87bn in revenues and with a profit margin of 37.60%. In contrast with Charles Schwab, TD Ameritrade’s revenue distribution is more heavily skewed toward trading fees, indeed they represented more than a third of its revenue last year.
The last broker we take into consideration is E*Trade which as Q4 2018 had $414bn in total customer assets with 4.9m active brokerage accounts. E*Trade had $2.99bn in revenue and a profit margin of 35.26%. With respect to TD Ameritrade, E*Trade is less exposed to the zero-fee offering because trading fee represented 17% of its revenues last year, yet E*Trade is expected to lose about $75m per quarter in revenue based on its second-quarter results.
The discount brokerage industry have changed in these days, today there is less trading and the real money is in investment advice, monetising idle cash in client accounts and providing custodian services to registered investment adviser. The opportunity going forward will be about helping clients invest with more insight, not helping them trade. Still the move of cutting trading fees to zero wasn’t painless: $1.6bn is the combined expected revenue shrinkage caused by the zero-fee offering for Charles Schwab, TD Ameritrade and E*Trade.
Challengers – commission free trading
- Robinhood was founded in 2013 by two engineers who formerly built high-frequency trading infrastructure for financial institutions. It is a trading platform that offers commission free trading of U.S. equities, options, cryptocurrencies, as well as selected Canadian and Israeli securities (international trades have commissions. Unlike other brokerages, Robinhood does not support short selling. As of 2018, the platform had executed $150bn in trades since inception. After its most recent funding round in July, the company was valued at $7.6bn. The company currently has 10 million users, up from 6 million at the end of last year, and is estimated to have earned $172.5m in revenues in 2018. It also caters to the millennial demographic, with 80% of the company’s users belonging to the demographic in 2015 and the average age per user being 26.
Robinhood earns its revenue from three main components: interest on uninvested cash, margin lending, and payment for order flow. With the first two segments being relatively easy to understand, order flow revenue is relatively opaque and generates the most controversy for Robinhood. According to some studies, order flow revenue comprised 40% of Robinhood’s total revenue last year, growing 227% from 2017. It works like this: because of Robinhood’s relatively small size, it allows customers to make trades on its platform but it does not execute the trades itself. Instead, it outsources the execution to high frequency traders like Citadel, Two Sigma and Wolverine Securities. These firms then pay Robinhood a fee per share for the right to execute these trades which, in Robinhood’s case, is estimated to be an average of less than $0.0024 per share. The problem with this is that Robinhood is not required to choose a market maker for their execution quality/price but can instead just choose them based on the fee per share it receives, meaning that customers may not get the best prices for their trades. This can even be seen in practice, as in 2018 Robinhood allocated 60% of its trades to Citadel Securities, which pays Robinhood around $0.0024 per share, and only 16% to Two Sigma Securities, which paid $0.0016 per share, and 19% to Wolverine securities, which paid less than $0.0016 per share. Analysts have also found that market makers pay Robinhood an average of 10x per share compared to what they pay to other brokers like Schwab and TD Ameritrade, likely due to the poorer execution prices that Robinhood accepts. Some other problems with the platform are the inability to short sell and the platform not offering certain stocks that are considered thinly traded and/or volatile.
For future growth, it is evident that Robinhood is attempting to move into value-added services and become more like a full-service bank rather than primarily a brokerage. The firm was in talks with the U.S. government to receive a banking license, but withdrew the application once it realized it wouldn’t have gone through. It has also recently unveiled a cash management feature for normal transactions. This was the result of a failed attempt to launch checking accounts that offered rates of 3% APY. With the Robinhood claiming that deposits will be invested into US treasuries, which offer rates of only 1.5%, and deposits not being insured by the US government, the launch was cancelled. However, recently Robinhood has come with a new iteration of the feature called cash management. Through this feature, instead of a separate checking account, users will be able to earn interest on the cash balance of its investment account at 1.8% APY and be able to access said cash with a debit card. In partnership with 6 banks, users will gain access to 75,000 ATMs and will not have to pay any maintenance, transaction, or opening fees. The feature is currently only operating a waiting list, with the expected launch still unknown.
Challengers – Savings focused companies:
These platforms cater to individuals who want to park their money in financial markets but do not want to actually go through process of trading and/or want a more safer portfolio for a long time horizon. This has led to the rise of companies that offer users exposure to financial markets through simple ETF like products. Two such examples are Acorns and Betterment.
- Founded in 2012, Acorns allows users to save using their “round-up” function. After connecting their credit card, anytime a user makes a purchase, the purchase price is rounded up to the nearest dollar and the extra money flows into the user’s Acorns account. For example, if a user purchases something for $5.5, the purchase is rounded up to $6 and the $0.5 is funneled into the users Acorn account. Funds from the round-up function, along with any other funds that the user chooses to invest, are automatically invested in one of Acorns’s five funds: Conservative, Moderately Conservative, Moderate, Moderately Aggressive, and Aggressive. Each fund is essentially just made up of ETFs from Vanguard or Blackrock. These ETFs track U.S. large-cap, U.S. small cap, international large cap, emerging markets, real estate stocks as well as corporate and government bonds, with each ETF having a different weighting depending on the risk profile of the fund. The platform also offers retirement accounts, providing retirement planning for users based on their investment needs and circumstances. Lastly, it has a retail banking segment, with checking accounts, that offer debit cards and free ATM use, connected to its investment and retirement accounts. The pricing for all three accounts (investment, retail, retirement) is $3/month. With 4.5 million users, the company has $1.2bn under management and was recently valued at $850mm
- Founded in 2008, Betterment is U.S. based robo-advisor that was valued at $800mm in 2017. The platform first collects personal and financial information from users. It then asks them to input goals (i.e. retirement savings, retirement income, safety net, major purchase, general investing) and then attach a target time horizon and target asset allocation to each goal. The platform then analyzes all the data and creates a unique portfolio comprised of ETFs (Large cap, mid-cap, small cap, emerging markets…etc) and Bonds (municipal, treasuries, emerging markets…etc). Users can then edit their portfolio composition and see the changes to their returns and goals. The platform also has a retirement planning service as well as a checking account similar to that of Acorns. In terms of pricing, Betterment charges 0.25% of the value of an account per year for the base model and 0.40% for the premium (which gives you access to a team of financial advisors via phone call or email). According to research, consumers will park over $2trn in robo-advisors like Betterment by 2020. As of this year the firm had $16.4bn of assets under management.
It is likely that a significant portion of users at traditional brokerages are not active traders and use their capital for long-term savings. Platforms like Acorns and Betterment lack the range of functions and flexibility offered by the brokerages, but in return the simplicity and low-risk that they offer can be very compelling to this demographic.
Case study: Schwab and Ameritrade
The Charles Schwab Corp. [SCHW:NYSE] – Mkt cap as of 08/12/19: $62.77bn
TD Ameritrade Holding Corp. [AMTD:NASDAQ] – Mkt cap as of 08/12/19: $27.69bn
On November 25, 2019, The Charles Schwab Corporation announced it will buy TD Ameritrade in an all-stock transaction worth approximately $26bn. The acquisition represents a significant shake-up of the retail brokerage industry, since closing the deal will create a company with more than $5tn in clients’ assets, 24m funded client accounts, expected $17bn in annual revenues, and $7bn in EBT. The agreement terms reveal that each TD Ameritrade shareholder will receive 1.08 Schwab shares for each TD Ameritrade share he/she owns, which constitutes a 17% premium over the 30-day volume weighted average price exchange ratio as of November 20, 2019.
In terms of ownership, after closing the deal existing Schwab and Ameritrade shareholders are expected to hold respectively 69% and 18% of the combined firm, while the remaining 13% will be owned by the Toronto-Dominion bank (“TD Bank”, which currently has approx. 43% of Ameritrade’s common stock). TD Bank will have the right of two new seats on the Schwab Board, but its voting stake will be restricted to 9.9% with the remaining part being non-voting class stock. TD Ameritrade will name one director.
The deal is expected to close in the second half of 2020 and boost the companies’ GAAP EPS by 10 to 15% within three years post-closing. The new entity will benefit from staggering expected expense synergies up to $2bn achieved by eliminating duplicate roles (surprisingly the largest cost for both companies are the salaries, followed by IT expenses) and unifying the trading platforms.
Integration-wise, the process of uniting the two companies will supposedly take 18 to 36 months post-closing. The combined firm will locate its headquarters in Schwab’s new campus in Westlake, Texas, moving from current headquarters in San Francisco.
Credit Suisse Securities are acting as financial advisor to Charles Schwab Corp. while Davis Polk & Wardwell are providing legal advice. TD Ameritrade is working with PJT Partners and Sandler O’Neill + Partners as financial advisors and with Wachtell, Lipton, Rosen & Katz as legal ones.
The transaction may be considered a strategic move with respect to competitors and also a logical one, given that the two companies operate on similar business models and Ameritrade does not currently have a permanent CEO.
In the beginning of October, Schwab eliminated commissions, forcing all of the competitors TD Ameritrade, E*Trade, Ally Invest, and Fidelity to do the same. In this situation of zero fees, competitors in the industry have to look for ways to keep up, a possible solution to which is consolidation. In a recent interview Schwab founder and chairman Charles Schwab reported that we are going to witness more firms getting together and that one just has to have that scale and volume. The combined Schwab-Ameritrade entity (the new company will carry the Schwab name) will benefit from scale economies in terms of fixed costs and tech investments and from further expansion of its service range.
Forming such a large financial institution to serve the investment, trading, and wealth management needs of its customers, however, may come with some challenging regulatory and antitrust issues. According to formal official with the Justice Department’s antitrust division Robert Litan, it is likely that the transaction will be reviewed by the Justice Department instead of the Federal Trade Commission and antitrust officials’ focus will be on whether this merger will stimulate more fees on other services and whether it will imply less competition for the interest paid to investors on their accounts. However, Schwab CEO downplayed this risk as the industry is going through a deep shake up and in this markets threatened by new challengers the antitrust authorities were more indulgent to let also big mergers be finalized.
Overall it is evident that the winner in this situation is Charles Schwab, being able to sustain much more effectively the lack of transaction fees than its competitors, strong of its other more stable sources of revenues and of the acquisition of one of its strongest historical rivals. The battle now its ready to start, but as advisory becomes more important and the link with banking services, which Schwab possesses, becomes a comparative advantage while on the other hand the new challengers are still struggling with, it seems that for now the incumbents still have a strong hold on the market. This is very well reflected in Schwab’s stock performance, which, after a 16% drop in prices after the announcement of transaction fees cancellation, was quickly recognised by the markets as the one best positioned to capitalize on the transformation gaining an impressive 39% in market value since the beginning of october.