Money for Nothing...Are Discount Brokers in Dire Straits?

The discount brokers are reeling this morning with the news that Bank of America is offering free commission trading for customers with more than $25,000 in deposits. This follows a recent announcement by Zecco.com that it was also offering zero commissions to its clients. The BAC announcement is limited to its Northeast customer base at this point.

Bank of America Zecco

What are the implications of “giving it away” to the online brokers. In my view, less than you would think.Discounting of brokerage commissions was the initial raison d’etre for the online industry and pricing competition has always existed. The “average” customer generates little more than $100 in commissions per year. For those traders who are more active than this, pricing is NOT the only consideration, I would think.

Execution is an important factor in differentiating discount brokers. The ease of use and functionality of the portal is critical to many traders. Those who choose to be very active traders are already getting substantial “deals” below the “suggested retail price.” Check out Barron’s Electronic Investor for other parameters by which these discount brokers are judged.

Access to research can be another important factor in selecting an on-line broker and Schwab appears to be unique in providing much of its own in-house expertise. A recent Barron’s article (subscription required) highlighted Schwab’s very good long term record which is largely quantitatively based.

This is not a radical move for Bank of America. It already was offering $5-$10 commissions well below the average rates of $12.23 at ET, $12.52 at AMTD, and $13.47 at SCHW. There are more streams of income than just commissions.

E-Trade, for example, offers a 3.20% rate on deposits between $5 grand and $50 grand compared to BAC’s 2.28%. Consequently, for the average customer who will be saving $100 in commissions to get the zero commissions at BAC, he is giving up an annual interest income of $230. Doesn’t sound like a very rational decision to me.

Many of the online brokers are encouraging fee-based advisory business rather than transactional business. Hence, management fees as well as substantial interest spread income can be generated. AMTD is selling at less than 15 times EV/EBIT on TTM EBIT for a business that generated about 18.5% ROIC. E-Trade sells at less than 12 times EV/EBIT with a ROIC that is quite modest at 1.5%. Schwab sells at 14.4 times EV/EBIT with a ROIC of 18% as well.

Don’t over-react as it appears many on the Street have.

As of noon,

Ameritrade (AMTD) is down 10.5%, E-Trade (ET) is down 9.5%, and Schwab (SCHW) is down about 5%.

Disclaimer: I, and my family do not own any of the securities mentioned above. Certain clients own a current position in Schwab.