How Does Td Ameritrade Make Money With Zero Commission

Recently, Interactive Brokers (NASDAQ:IBKR) and Schwab (NYSE:SCHW) got rid of stock trading commissions, creating a major shake-up in the brokerage industry, and competitors TD Ameritrade (NASDAQ:AMTD) and E*Trade (NASDAQ:ETFC) quickly followed suit.

In this Industry Focus: Financials clip, host Jason Moser and Fool.com contributor Matt Frankel, CFP, discuss what this news means to individual investors and to the brokerage industry as a whole.

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This video was recorded on Oct. 7, 2019.

Jason Moser: Let's jump into to the big news from last week. This was news that played out on a number of different companies out there. On Tuesday last week, Charles Schwab announced that it was eliminating commissions on stock trading altogether. Man, did that set off a chain of events. And by a chain of events, I mean there was a lot of selling of a lot of these big-name brokerages that we know. Just looking at some of the numbers from some of the bigger players in the space, last week, TD Ameritrade shares were down 28%. Schwab shares were down 15%. E*Trade was down 17%. Interactive Brokers was down 11.5%, all on this news. Essentially, these brokerages have now gotten to the finish line of this race to zero. We're not going to be able to really go back to charging for commissions, I don't think. It affects some businesses a bit more than others. Talk a little bit about what you thought about this news, and what companies you feel like this affects the most.

Matt Frankel: For one thing, this is an obvious win for investors. Commissions aren't usually a big part of my investment strategy. Having said that, this makes it practical to buy, say, one or two shares of stock at a time. Before, if you had just a couple of hundred bucks of cash sitting in your account, it wasn't really practical to buy one share of Apple. Now, investors can do that. It helps you maximize your investment dollars.

I think the winners of this are, surprisingly, going to be the companies that were charging the most. Let me tell you why I think that. First of all, in full disclosure, I use TD Ameritrade as my broker.

Moser: As do I.

Frankel: The product's fantastic.

Moser: It is. I agree.

Frankel: Excellent access to research. Their educational tools are the best that I've seen. And I've used E*Trade and Merrill Edge in the past, so I have some basis for comparison. Their product is hands-down the best. But it seems counterintuitive that they were charging the most, and I think they're going to be the biggest winner. So let me tell you why.

Two big reasons. One, about 25% of their revenue previously came from commissions. That's pretty much going away. It's important to note that it's not going to zero. They're not eliminating all commissions. For example, an options trade would still have somewhat of a commission. It's not going to go to zero. Let's say, just for argument's sake, they lose 20% of their revenue. They've already dropped 28%. So that's more than priced into the stock at this point. The more important point is, just to name three competitors, you have Robinhood, which has been free; Schwab, which had been charging $4.95 previous to this move; and TD Ameritrade, which was charging $6.95 previous to this move. And it made sense. Robinhood was a no-frills platform, but it was free. It catered to that crowd. Schwab had a little bit more features. A nicer platform, more research available, stuff like that. And it was mid-priced. TD Ameritrade was a premium product that you paid for. Now, you can get a premium product from a TD Ameritrade or an E*Trade without having to pay that premium. So, I see a lot of people jumping ship from companies like Robinhood to bring their assets over to TD Ameritrade. They make money off interest income. They earn some interest on people's idle cash balances, they make some money off that. They get some interchange fees from the market makers when people place orders. They have a lot of other ways to make money off of customers' assets. So, I see this being a net win for TD Ameritrade and E*Trade. I think they're going to end up getting a nice trickle-down effect from the previously discounted brokerages, because now there's no such thing as a discount brokerage. They're all zero. All the big ones, anyway. You're going to see them get a nice little stream of assets from people who were just with companies like Robinhood because they were free. If you went to a Honda dealership and they were selling Hondas and Acuras for the same price, which one are you going to buy?

Moser: That's a good point. It makes sense to me. I remember the days when commissions were $50. I remember calling my Edward Jones broker on the phone when I was younger, placing a trade and paying a $50 commission. That'll make you think. The point is, the trend has always been going toward zero. This is not something where they're just ripping the Band-Aid off, so to speak, and going from $50 to zero. I mean, it's been a trend that's been established over a long period of time. I guess that's why I was a bit surprised to see such a reaction in the markets. With these particular names specifically, it felt like an overreaction. I feel like these are businesses that are very well-rounded, have a lot of different ways to win, vs. something like a Robinhood, as you were talking about before. Robinhood, that's a one trick pony. That was their thing, was zero commissions. They don't have much of a business built around that. Just because the private valuation had them at somewhere around $8 billion, we know how private valuations work out. We've watched this WeWork drama play out, obviously. And it's not the only one. I would imagine the valuation on Robinhood behind closed doors has taken quite a haircut already. I tend to agree with you. It's just a matter of making sure that they figure out other ways to find that growth.

Frankel: Yeah. I was going to say, the market should be glad that Robinhood hasn't gone public yet. You think the IPO market's had a bad year so far already? If they'd gone public before this happened...

Moser: They would not be so forgiving, I don't think.

Frankel: Right. I put out a tweet about this shortly after the news came out about, what's the value case for Robinhood. And not one person responded with something like, "Oh, I'm going to stick with Robinhood because... " Most people were like, "Now I'm going to jump into E*Trade because I can afford to." They're getting these newer investors who are who have $50, $100 at a time, who, previously it was only practical to invest through a company like Robinhood. They're going to get this nice trickle effect from that. There are more ways these can grow. The lost commission revenue in all cases has been more than priced into these stocks. I think this is a big win for investors. And at the newer valuation, it's a big win for the companies as investments.

Moser: Big win for investors. Of course, we're not saying, "Hey, because it's free, get out there and trade more." We're not saying big win from that perspective. Don't up your trading volume. That's obviously not the way we invest here. But you are getting your trades for free now, which is nice. Just, obviously, don't let this encourage more short-term trading behavior. We've seen how that works out. It typically is not good. It's certainly not in line with the way we invest. Like you, Matt, I don't make a lot of trades. I don't really consider commissions when it comes to the trades or the purchases or sales that I'm making because I make so few, and typically I try to be a net buyer of stocks anyway. When you look at it from that context, it's not going to kill either one of our bottom lines. It's not going to make either one of our bottom lines all that more robust. But I do feel like, when you look at these four businesses that I talked about earlier there -- TD Ameritrade, Schwab, E*Trade, and Interactive Brokers -- you can almost, dare I say, take a basket approach and take advantage of the market's short-term pessimism here. These are four very proven businesses with models that seem to work. It did strike me as a bit of an overreaction. I guess time will tell. But certainly, it's a new day for investors. I think that's a good thing.

Frankel: Definitely. Like I said, I think it's a big win for investors. In terms of being a stock investor and being an investor in these businesses, if you're looking for something to watch -- it's not my One to Watch this week, but I'll go ahead and add companies like TD Ameritrade and E*Trade to my watch list on the back of this news.

This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.