Price wars have been going on in the brokerage world for decades. But the latest battle just may be the last, at least when it comes to trading commissions.

Almost all of the major brokerage firms—Charles Schwab (ticker: SCHW), E*Trade Financial (ETFC), Interactive Brokers Group (IBKR), and TD Ameritrade Holding (AMTD)—slashed equity-trading commissions to zero this week. (Fidelity and Vanguard seem to be holding out—for now.) The rapid-fire cuts caught investors and analysts by surprise, sending the stocks reeling as it became apparent that commissions would be going the way of ticker tape. While customers of the firms may be delighted, analysts slashed their estimates and tried to figure out who the winners and losers would be once the dust settles.

If there is a winner, it is likely to be Schwab, though the company faces significant near-term challenges. Schwab has a history of disrupting established industry practices and prices. It’s well capitalized, broadly diversified, and managed with an eye toward long-term growth. Going to free trading neutralizes the main marketing pitch of start-up trading apps like Robinhood. And Schwab is likely to emerge stronger than rivals that don’t have Schwab’s diverse business lines to prop up revenue as commissions slip away.

“It’s a strategy they’ve employed for a long time, and it works,” says Wells Fargo analyst Christopher Harris. “That’s why they’re one of the largest brokerages.”

The price war comes at a tense time for the industry. The bull market that lifted brokers’ asset levels and profits for a decade may be winding down as global growth slows and a recession looms, potentially in 2020. Interest rates are also heading down, pinching a critical source of revenue: net interest income that brokers earn by reinvesting customer cash.

Schwab now derives more than half of its revenue from net interest income, and the company estimates that it will lose $75 million to $150 million in revenue for every quarter-point cut by the Federal Reserve. If we get four more cuts over the next 12 months, Schwab could lose $600 million, about 6% of its estimated $10.6 billion total.

“People underestimate how much the economics of Schwab’s business comes from investing client cash,” says Steven Chubak, an analyst with Wolfe Research. “Rising rates were a very good story for them, but rates may now be going in the other direction, and that will create headwinds,” says Devin Ryan, an analyst with JMP Securities.

What does Schwab—a longtime leader in cutting prices—have to say about all this? And what’s next for the company as it grapples with tectonic industry shifts?

The company issued some commentary on why it cut commissions, saying it was “challenging the status quo on behalf of individual investors.” But Schwab declined requests from Barron’s—from before and after the zero-commission announcement—to interview CEO Walter Bettinger, company executives, or Chairman Charles Schwab.

Schwab and others in the industry face a much tougher competitive landscape. Competition for retail brokerage is intensifying, both from start-ups like Robinhood and large Wall Street players. Robinhood is courting millennials with commission-free trading, social media, cryptocurrencies, and new ways to trade; it now has more than six million accounts, its own clearing system, and a $7.6 billion valuation, based on its latest funding round. (E*Trade’s market cap is $8.6 billion by contrast). StockTwits is expected to introduce a trading app soon. Square, the payments app, is testing stock-trading on its app with employees, according to Bloomberg.

Wall Street is looking at retail brokerage, too. Investors with banking relationships at the Merrill Lynch unit of Bank of America (BAC) and JPMorgan Chase (JPM) can trade free on a limited basis. JPMorgan CEO Jamie Dimon mentioned Schwab seven times in a recent meeting with analysts, more than any other rival, according to Chubak. “Dimon said he would ‘do whatever it takes’ to defeat competitors,” Chubak wrote in a note to clients. “That’s good for JPM but bad for online brokers.” Goldman Sachs Group (GS) may be coming, too, as it builds out a consumer banking business, Marcus, which it may extend to brokerage.

Against this backdrop, the move to commission-free trading by the brokers was inevitable. Charging $4.95 a trade—Schwab’s price before the cuts—was starting to look like an anachronism in the face of zero commissions at the big banks and start-ups. Interactive Brokers kicked off the price war with an announcement that it would offer commission-free trades. Schwab and the other brokers followed with their own cuts. As Schwab’s chief financial officer, Peter Crawford, indicated in a commentary, Schwab cut prices because it was better to be safe than sorry. “It has seemed inevitable that commissions would head toward zero, so why wait?” he wrote.

The reaction by investors implies that E*Trade and TD Ameritrade will be hurt much more than Schwab. Shares of E*Trade fell 16% and TD slumped 28% this week, while Schwab took a 14% hit. A big reason that E*Trade and TD fell more than Schwab is that they depend on trading much more heavily. Trading is 16% of revenue at E*Trade and 24% at TD. It’s only 8% for Schwab, and it has been falling for years, partly because of price cuts, but also because other revenue sources have expanded. Schwab estimates that its new pricing will affect $360 million to $400 million in annual revenue, about 3.5% of its $10.6 billion total.

Schwab can withstand the revenue loss. It is one of the most broadly diversified brokerages, including asset-management, custodial, and back-office services for institutional investors. Based in San Francisco, the firm oversees $3.7 trillion in client assets, including $1.55 trillion custodied by registered investment advisor firms, or RIAs. Schwab is the largest RIA custodian in the country. The company sponsors mutual funds and exchange-traded funds. Its Intelligent Portfolios service—automated managed accounts of ETFs—has grown into the largest robo-advisor with $30 billion in assets.

The big profit center for Schwab is now its bank. With more than $276 billion in assets, Schwab Bank is larger than Ally Financial, KeyCorp, and Fifth Third Bancorp, according to S&P Global Market Intelligence. Schwab Bank recently crossed a regulatory threshold, subjecting it to stiffer federal stress-test, capital, and liquidity requirements.

As rates increased in recent years, Schwab Bank became the tail that wags the company dog. Net interest revenue from the bank amounted to $5.8 billion, or 57% of Schwab’s total revenue of $10.1 billion in 2018, up 36% year over year. Management and administrative fees were 32% of revenue in 2018, with trading and related revenue rounding out the pie.

Schwab started its bank in 2003, after the dot-com bubble burst and online banking was taking off with the housing boom. Banking-based revenue from high-quality mortgages and interest income could be steadier than trading. And Schwab has made a decadelong push to fund its bank with brokerage-held cash deposits.

One way that Schwab did this was by making it less convenient for customers to hold money-market funds in brokerage sweep accounts, requiring that the funds be bought and sold for liquidity. Sweep accounts are used by customers for settling trades and other purposes, and most customers keep some cash in these accounts for convenience. Schwab, however, has eliminated money markets for sweep purposes (as have other brokers), and it recently completed a push to default customers into cash sweep deposits, rather than money markets. Investors can still buy a money-market fund in a sweep account, but they have to place a sell order if they want the cash the next business day.

The upshot: Schwab’s balance sheet has grown considerably, funded largely by brokerage customer cash. And net interest income has fueled revenue and profit growth. Schwab’s interest-earning assets produced an average 2.6% yield in 2018, well above its 1.8% average yield on assets in 2016. Net interest is expected to be 60% of Schwab’s total revenue this year, according to Harris of Wells Fargo, amounting to $6.3 billion.

A side effect of all this is that Schwab’s stock has become a proxy for interest rates. Since 2016, the stock has had an 86% correlation to the 10-year Treasury yield and a 69% correlation to the federal-funds rate, Chubak of Wolfe Research says. The stock is so closely tied to rates that investors shouldn’t overthink it. “It’s like Occam’s razor,” he says, “If rates move down, so does the stock.”

While falling rates will certainly hurt Schwab’s financial results, it may be an even bigger issue for its rivals as commission revenue disappears at the same time. Harris estimates that trading will drop to 10% of revenue from 24% at TD, while interest-sensitive revenue goes to 64% from 54% of its total. For E*Trade, he sees trading falling to 7% from 16% of the total, with interest-based revenue rising to 76% from 68%.

Schwab has been taking a variety of steps to prepare for the day when rates would come down and commissions go away. For one, it has bulked up its asset-management business; the firm recently acquired customer assets worth $90 billion from USAA, the financial services organization for military families.

Schwab’s revenue base now looks well balanced between RIA sources (such as custodial fees) and retail brokerage, Chubak says. The company’s low-cost ETFs and robo-advisory service are marketplace winners. Schwab recently rolled out a premium subscription advisory service offering “unlimited guidance” for $30 a month and a one-time planning fee of $300. Schwab CEO Bettinger said on a recent call with analysts that the premium subscription service “seems to have really taken off in terms of client interest and response.”

Schwab’s platform for RIAs is considered one of the strongest suites of tools and software in the industry. And it is benefiting as advisors break away from Wall Street brokerage houses. The trend has been going on for a decade, but it may be gaining momentum. Bettinger said recently that the breakaway RIA trend began “to pick up a bit again in the second quarter.” Schwab recently launched an upgraded version of its portfolio-management software to compete more effectively.

“Schwab’s competitive strength is their enormous stronghold on the advisor community,” says Thomas Peterffy, chairman of Interactive Brokers. “They have cultivated that for years.” The RIA industry is also consolidating into firms with 50 to 100 advisors, says Chip Roame, managing partner of Tiburon Strategic Advisors, a financial consulting firm. That’s good news for Schwab, since larger firms with more trading, analytics, and custodial requirements are likely to bring assets to the firm.

Roame adds that Schwab should capitalize off two long-term trends: subscription-based pricing for asset management and growing demand for “episodic” advice.

“The future is subscription-based fees for investment management, and they have a great offering on that path,” he says. Investors will probably pay for one-shot advice when they have a life-changing event like a birth or death in the family. He says that Schwab is “ideally positioned” with its legions of advisors available by phone or at its hundreds of branches nationwide.

Schwab is also housecleaning to prepare for lower rates. It recently cut 600 jobs, amounting to 3% of its staff. And Schwab is counting on customer inertia. In a lower-rate climate, customers will be less inclined to move money out of cash deposits into higher-yielding funds and fixed-income securities. Schwab calls that process “cash sorting,” and it may be winding down. “It’s too early to ring the bell and call the end of client cash sorting, but I think there is little doubt that the behavior is slowing,” CFO Crawford told analysts.

One other way that Schwab can manage lower rates is by adjusting its interest-earning asset mix. Schwab has been shifting assets on its balance sheet to short-term, fixed-rate securities that don’t immediately adjust to lower rates. Schwab also tends to reduce the rate it pays on customer deposits as rates fall more than it increases yields on deposits as rates increase, says Richard Repetto, an analyst with Sandler O’Neill. Most banks do the same thing. That dynamic helps preserve some profit in the early innings of falling rates.

Falling rates aren’t the only headwind for Schwab and other brokers. Pricing pressure may start to affect other parts of the brokerage world. Areas ripe for cuts include ETF expense ratios, mutual fund transaction fees, derivatives, and options trading. A big challenge is dealing with the trend of investors shifting assets from actively managed mutual funds to lower-cost index funds, where fees are also heading to zero—another trend largely driven by Schwab.

As annual fund fees come down, brokers are hurt in two ways: They must charge less for their own proprietary funds to remain competitive, and it limits their ability to collect higher fees from other asset managers who pay to be on their platforms.

Analysts aren’t particularly bullish on the near-term prospects for Schwab’s stock, or the other brokers. Wells Fargo’s Harris downgraded his ratings of TD, E*Trade, and Schwab, and slashed his price targets on the industry by an average 28%. “Organic growth is slowing,” he says, “rates are declining, and significant chunks of trading revenue are going away.” Consensus estimates for Schwab’s 2020 profits have fallen to $2.54 a share from $3.21 last November, a decline of 21%. Other brokers have taken a similar hit to estimates.

Brokers can’t control interest rates, of course, making them more vulnerable to macroeconomic trends. And the fact that brokers cut commissions so quickly implies that customers “don’t assign much value” to their other products and services, Harris says. The only positives he sees are expense cuts and stock buybacks, but those won’t support the stock’s multiples like organic growth. “Identifying a bull case for the group now has become very difficult,” he says.

Job cuts and consolidation may be coming as weaker players (notably E*Trade) retrench. The industry will get through this rough patch. But it won’t look the same. Subscription-based pricing could emerge: Customers that trade heavily and want lots of tools and data may pay a flat monthly charge, while casual traders could trade free as an inducement to keep their business in-house for other products or services.

Some of this is happening. Interactive plans to bifurcate customers between “lite” and “pro” versions of its trading system. Lite customers will get commission-free trades, while pro customers will pay commissions but get better trade execution (known as price improvement).

“For those who care more about execution quality, we’ll charge commissions,” Peterffy says. “For customers who don’t trade that often, and execution quality doesn’t matter as much, we’ll allow them to trade for nothing.”

Brokers aren’t in the charity business, though. Commissions can go to zero because brokers can still profit. One way is with “payment for order flow.” Brokers sell customers’ stock orders to “wholesale” market makers like Citadel Securities, Virtu Financial (VIRT), and others. The wholesalers pocket fractions of a penny on vast quantities of trades, and brokerages still meet their obligations to provide customers with “best execution.” Commission-free trading could fuel higher volume, increasing payments for order flow. Other revenue streams in the trading bucket include margin interest, securities lending, and options (which still cost 65 cents a contract at Schwab and aren’t commission-free at other firms).

Retail brokerage remains immensely profitable. Online brokers generate pretax margins of 30% to 60%, Petterfy points out, higher than in many other industries. “Even though we’re the lowest-price broker, our margins are still high,” he says. Customer cash held in brokerage accounts remains a cheap source of funding for interest income. “That 2% difference between what we pay on cash and what we charge on margin loans amounts to a great deal of money,” he says.

One other point to bear in mind: Lower trading costs have a downside. That might seem counterintuitive; everyone wants to pay less. But stock trading involves emotions (fear and greed) that can overwhelm rational decision-making. Removing a cost eliminates a barrier, encouraging people to trade more, potentially to their detriment.

“Let the industry go goo-goo eyes over fee compression, but the bottom line is still that trading is a fool’s errand,” warns Daniel Wiener, chairman of Adviser Investments. Jim Lowell, an advisor and longtime industry follower, also cautions against getting carried away. “Trading is a gambit, not a discipline, and if zero fees lead investors to trade more, I’d view it as a negative,” he says.

If there’s a silver lining for the brokers, it’s that trading costs probably won’t go below zero. Whether brokers are doing investors a favor remains to be seen.

Write to Daren Fonda at daren.fonda@barrons.com

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