Once upon a time in college, my Econ 101 professor opened up his first lecture with a very curious statement, saying, “There is no such thing as a free lunch,” as the theme for what we were about to learn that semester.
This made no sense to the 18-year-old me at the time, as I had enjoyed many free lunches. However, after a deep dive into the world of economics, it became quite apparent that his metaphor for how the world works, supply/demand relationships, business arrangements and, when it comes to financial services, non-transparent pricing, was spot on.
Case in point: how some brokerage firms and their affiliated banks play strategic games with pricing of their various products, services and technology.
In a world of $5 trades, “free” robo-advisors, and “$30 a month to talk to a CFP” subscriptions, it has become very difficult for discount brokers to remain profitable as technology and competition has commoditized many of the services they provide, so they must look elsewhere to finance their disruptive strategies.
And that brings us to probably one of the most overlooked asset classes out there: cash. Believe it or not, regular old money is an incredible driver of profitability for brokers, online and otherwise.
According to an analysis done by Forbes magazine in early 2018, one firm’s interest income accounted for over 60% of its stock market valuation and over 12 times the value contribution of its trading commissions.
Some broker-dealers have the ability to sweep idle cash in their DIY brokerage accounts into their banks. Investors and independent advisors can purchase higher-yielding cash products (aka money-market funds), but it does require a call or a few clicks.
A recent Barron’s article, for instance, noted that Merrill Lynch, Charles Schwab, TD Ameritrade, E*trade Financial and Morgan Stanley have gotten rid of money markets for sweep purposes.
This situation may help the brokerages make up for their loss leaders of physical branches, retail financial consultants, and oh yes, $5 trades.
Combined with the higher leverage that increasing interest rates have provided these past several years, some online brokerages with strong support from their affiliated banks have been able to juice up their operating margins quite substantially. The old saying that “cash is king” has never been truer!
But with opportunity comes challenge — this time in the form of a recent broad-based strategic swipe at these cash practices among online brokers like Fidelity and Vanguard.
Both recently announced the start of a new “cash war” in broad marketing terms through full-page comparison ads in The Wall Street Journal, press releases, social media posts and other communication channels, highlighting that they, of course, do not automatically sweep DIY investors into paltry paying bank products, but rather into much, much higher-yielding money market alternatives.
Even the independent robo-advisors Wealthfront and Betterment have jumped into the cash wars, by pivoting their core businesses away from their unprofitable robo investing services into trying to become online banks with offers of higher yields on cash products.
They too, know the vulnerability of the online brokers’ dependence on harvesting cash to stay profitable, and are clutching at these last-minute pivots themselves to remain sustainable in a world of “free” robo advisory services.
Schwab’s robo, for instance, mandates a minimum allocation to its bank’s cash in order to provide the robo for “no advisory fees and no commissions.”