The business of being a custodian for independent RIAs is generally considered a bit “boring.” And that’s pretty much how it’s been for the last 30-plus years.
After all, what do they do? Open brokerage accounts, keep client assets safe and secure, process trades and money movements, deliver statements and provide basic operational technology through some form of an online advisor workstation.
That’s about it — a sleepy, commoditized corner of the financial services industry if there ever was one.
Meanwhile, RIAs do all of the heavy lifting by acquiring clients and managing relationships, while implementing investment and financial plans, all under their own brand. At the same time, RIAs benefit greatly from the resources, services and economics of their chosen custodian in driving operational efficiencies.
Pricing for custodial work typically has been paid by the end-client as custodians automated all sorts of non-transparent pricing schemes to keep costs for RIAs “free,” providing RIAs with operational leverage to continue to grow.
To provide these no-cost custodial services, though, custodian brokers needed to revenue share with mutual funds, accept payments for order flow from institutional traders, harvest end-client cash through bank sweep programs and profit from trading commissions (until recently), margin lending and other product related fees.
These multiple revenue streams made custodians one of the most profitable entities in all of wealth management, as RIAs’ relentless asset gathering ability over the years transformed wealth management, gained market share and powered custodians’ growth.
Life was good, advisors were happy, and custodians started showering them with new technology and practice- management help to keep the RIA bandwagon rolling along.
The New Scene
So, why now do we have so much drama building in this sleepy segment? The answer lies on the other side of the custodian house — in their retail divisions.
These businesses compete fiercely in a broader retail investment world, and as a result, conflicts arise, economics get flipped upside down, and chaos ensues.
Case in point: Charles Schwab let loose a “shot heard round the world” on Oct. 1, 2019, when it cut trading commissions to zero; many direct competitors quickly followed suit, though Interactive Brokers made the first move in the race to zero on Sept. 26.
The aftermath of Schwab’s headline-grabbing decision, along with TD Ameritrade’s copycat maneuver, is now ripping through the wealth management industry with tsunami-level force, changing the economic dynamics for advisors, custodians and investors forever.
One immediate result of zero commissions was the devastating impact to the entire online broker space, as stock prices of these brokers were pummeled to levels not seen in decades.
Two of the weaker players with RIA custody divisions, TD Ameritrade and E-Trade, were soon scooped up by rivals in opportunistic acquisition plays to gain economies of scale in a rapidly declining revenue environment.
While on the surface, this may not seem like an inflection point in the industry — trading commissions have been on the decline for years — this final push to zero put the industry spotlight back on how retail brokers/custodians really make money today: harvesting customers’ cash and receiving payment for order flows.
In fact, some 60% of Schwab’s entire revenues come from net interest income today; it was nearly $1.6 billion in the first quarter. Schwab trading revenue, which includes payments tied to order flows, stood at almost $190 million in Q1’20.
Meanwhile, as these dynamics played out, another devastating wrecking ball was let loose on the industry from the coronavirus pandemic. Government reaction was swift, with the Federal Reserve immediately cutting rates to zero, severely dampening the ability for retail brokers/custodians to harvest client cash.
Their Next Act
What happens to custodial revenues now? Will there be enough flow in a zero commission and zero interest rate environment to continue to support independent RIAs, particularly smaller firms who don’t generate as much revenues as larger RIAs for custodians?
The answer seems to be that they must pursue scale at all costs. This is exactly what has happened in the first half of 2020.
Schwab is well along the way to digesting TD Ameritrade, along with the technology of now-defunct Motif Investing, which sold its accounts to Folio in April. Folio then was purchased by Goldman Sachs, and that occurred a few months after Morgan Stanley jumped into the game by buying E-Trade.
So much for a sleepy corner of the financial services industry! As a result, it appears that scale is the new black.