There is no free lunch: The elimination of trading commissions

For the past five years you may have noticed that there has been a race to the bottom in trading fees among the behemoth financial services firms. The latest salvo was fired by Charles Schwab, which will no longer charge any fees on buying or selling securities. Fidelity, TD Ameritrade and E*Trade quickly followed suit and will no longer charge commissions on trades either.

To be fair, trading commissions now represent a much lower percentage of revenues to Schwab than they did five years ago, representing only 10% of revenue now. For Schwab, eliminating trading fees completely this month will have a much less deleterious impact on the company’s bottom line than TD Ameritrade and E*Trade, which get more than 20% of their revenues from commissions on trades.

So, for investors what does this really mean?

For one, there is no free lunch. While trading commissions have been basically eliminated, brokerage firms will make up the difference in several other ways. For example, it may cost clients more to keep their money on the sidelines at some of these firms.

Instead of moving any extra cash in clients’ accounts into competitive and higher-yielding money market funds that might currently yield 1.5% to 2%, Schwab is moving idle cash into its own Schwab b which pays between .10% and .50%. Currently, three-month U.S. Treasury bills are yielding three times more at 1.65%.

Brokerage firms also make money through margin loan lending. If you want to borrow money to refinance your mortgage, buy a new car or an investment property and don’t want the hassle or paperwork of going through a bank, borrowing on margin may be a lot easier and could potentially offer a lower rate.

For example, a brokerage firm may charge a spread of 2% off the current federal funds rate of 1.75% for an all-in loan rate of 3.75%. If the Federal Reserve continues to lower the Fed Funds rate, the margin rate will go lower too, but the brokerage firm will continue to make its spread of 2% regardless of what the Federal Reserve does with short term interest rates.

On the surface, commission-free trading seems like a great deal, but if the trade-off is an interest rate of just .25% instead of 1.5% on your cash balances, you may want to think twice.  As margin loans become an even more popular way to borrow money, investors will still have to pay a healthy spread to their broker to borrow this money.

Don’t get me wrong, commission-free trading is a positive development, but brokerage firms will still need to make money somehow to stay in business. Investors can save money by not keeping too much cash on the sidelines and negotiating the best margin rate possible. A good advisor will more than earn their fees by providing first rate customer service, prudent financial advice and most importantly, excellent investment returns over a long period of time.