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Free trading becomes 'the norm' as online brokers race to the bottom

Four leading U.S. online brokers will begin offering free trading in the coming weeks, marking a watershed moment for an industry that until now had resisted the growing momentum behind $0 commission fees.

The sea-change began Sept. 26 when Interactive Brokers Group Inc. said it would be launching a new free-trading platform called IBKR Lite in October. The announcement kicked off the brokerage industry's latest price war as Charles Schwab Corp. unveiled just a few days later that it would be slashing its $4.95 commission fee to zero for online trades involving U.S. stocks, options and exchange-traded funds. Hours after that, rival TD Ameritrade Holding Corp. said it would also eliminate its $6.95 commission fee for online trades involving those assets. And a day later, E*TRADE Financial Corp. followed suit, announcing it would no longer charge a $6.95 commission fee for trading the same assets.

"We have entered a new commission price war as 'free trading' has been moving from an aberration to the norm," JMP Securities analyst Devin Ryan wrote in an Oct. 1 research report following Schwab's announcement.

Across Wall Street, there has been a growing movement toward lowering fees to zero for years.

Robinhood Markets Inc., a Silicon Valley-based company expected to hit the public markets in the near future, was an early champion for free trading. Launched in 2013, the company now offers its clients the ability to trade stocks, ETFs, options and cryptocurrencies for free. Robinhood's debut did not immediately move the pricing needles at many Wall Street brokerage operations, but more well-established financial institutions such as JPMorgan Chase & Co. and Bank of America Corp.'s Merrill Edge have since started to offer a certain number of free trades to their customers.

Executives at the leading U.S. online brokerages have said these newer players do not represent an immediate threat to their business models. But, as Schwab CFO Peter Crawford wrote in a commentary that accompanied the company's announcement, the move toward free trading "seemed inevitable."

"We don't want to fall into the trap that a myriad of other firms in a variety of industries have fallen into and wait too long to respond to new entrants," Crawford wrote.

The decision to roll out free trading does represent an about-face for some of those companies, though. Schwab President and CEO Walt Bettinger II, who told S&P Global Market Intelligence in an interview in 2018 that "no one does trading for free," has been particularly vocal about concerns that free trading can lead to worse execution quality for investors. Former E*TRADE CEO Karl Roessner, who stepped down in August, said in 2018 that the last round of price cuts in the online brokerage industry "destroyed" the economics behind the business.

The online brokers are expected to take a significant revenue cut by introducing free trading.

Schwab indicated that it expects a $100-million-per-quarter revenue hit, while TD Ameritrade anticipates a $220 million to $240 million decline per quarter. E*TRADE estimated that the revenue impact from $0 trading on its second quarter results would have been about $75 million.

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"It will be very difficult for them to recoup that lost revenue in the near to medium term," said Michael Wong, a Morningstar analyst, in an interview. Wong was surprised how quickly TD Ameritrade followed Schwab's commitment to free trading. Commission fee revenue is a much more significant piece of TD Ameritrade's and E*TRADE's total revenue than it is for Schwab's revenue. Wong thought the two brokers might have waited to see if there were any net outflows before also dropping to zero.

This latest price-cutting war among the online brokers comes at a starkly different time than the industry's last pricing battle when asset prices and the stock market were rising. At that time, market participants expected interest rates to also rise, meaning online brokers were able to quickly replace the lost revenues with asset-based fees and net interest income, Wong said.

But this round of price cuts comes at "practically the worst time in a decade," Wong said, noting a slightly shaky economy and falling interest rates.

Against revenue headwinds, the "only lever" for these online brokers to try to pull to protect earnings is to cut expenses, he said. In September, a report surfaced that Schwab was getting ready to lay off 600 employees, roughly 3% of its staff, mostly in the retail division.

"That timing was quite interesting," Wong said.

Investors have punished the stocks of all four companies, with TD Ameritrade shares tanking the most. The broker's stock is down about 30% since Sept. 24.

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