Eagle, CO
How much does “free” cost? (part 2)
I finished my last blog with the following paragraph:
“Here is the thing… there is another really sneaky way these firms are making money. In the interest of your time, I will save that for the next blog. But, for now – just know that even though you see shares of AAPL on your statement – they may not actually be in your account! Sort of like the dollars in your bank account…”
So, that’s where we will pick up today. And again – I am not picking on any one broker. I am simply trying to meet my self-imposed obligation to tell you what I would want to know if our roles were reversed.
Many people understand that the dollars that you have sitting in your bank account aren’t actually sitting in your bank account, but for those who don’t - your dollars have generally been loaned out by the bank to folks in the form of mortgages.
The banks are borrowing short-term money from you and me and their cost for this money is the interest rate that they pay us each month in our checking and savings accounts – which is very little, today.
The bank then turns around and takes these dollars from your checking account and lends them to folks for 30 years at a time to buy homes. The bank charges the borrower 3.50% or so and uses the home as collateral – if the borrower can’t pay, the bank sells the house to get the money back.
The bank makes money by keeping the difference between what they pay you on checking and savings accounts, and what they charge others on mortgage and other loans. They are taking the risk that a high percentage of their checking account clients may want all their money back at once – a situation known as a “bank run” which has happened recurrently throughout history.
Brokerage Firms make money in the exact same way. Most firms pay very little, maybe 0.10% or so on cash sitting in your brokerage account. But they are investing that cash into US Treasuries (or something similar) and earning around 1.65% today. For example:
Do that a few billion times… and you can make enough money to give everything else away for “free”.
For example, E-TRADE generated around $5B over the past 3 years in “net interest income” compared to only $1.3B worth of commissions from executing trades.
But there is at least one more way the brokers will still make their money.
Beyond the spread being earned on cash, you can think of the shares of Apple (NASDAQ: AAPL) that you see sitting in your retirement account the same way as those dollars in your checking account – they aren’t really there.
I know it sounds crazy, but here is the language from a TD Ameritrade Account Application, for just one example: (if you read just the highlighted words it makes more sense…)
Why does this matter? Principles and money.
Well, who is TD lending the securities to? Who needs to borrow shares of AAPL, and for what purpose would they need to borrow them?
Answers:
1. Short-sellers are borrowing your securities.
2. Short-sellers then sell the securities in the open market, bringing the share price down (all else equal) and profiting from the drop.
3. Short-sellers pay the lender of the securities (in this case, the broker and NOT YOU) an interest rate for the borrow.
4. The purpose is to make money betting against long-term holders of the shares.
Now, there is nothing wrong with a company profiting from doing business with their clients, or “providing liquidity”. However, the ideas that commissions are “free” and that the brokerage firm shares none of this securities lending revenue with the actual client holding the shares is what bothers me the most. Even the banks pass on some of the interest!
For what it is worth, Interactive Brokers is the one exception in this practice that I am aware of. There may be others. Check out their “Yield Enhancement Program” for more information. But basically, it says you can opt-out of securities lending, or if you opt-in, they will share the interest with you.
This is how 0% ETFs work, too. How else would they be able to offer their services for “free”? (I feel like free should always be quoted…)
The ETF buys a basket of securities for the fund and rather than just sit on them in the fund account, they lend those shares to people who are willing to pay a lot more in interest than most people are willing to pay in fund fees.
It is extremely difficult and well outside the scope of this blog to analyze the total cost to society of all these activities. It seems to me like a fair, honest and known fee would be a lot lower in the aggregate, but I really can’t say for sure, today. The one thing to remember is that nothing in this life is free and in time, we will surely find out how this experiment works.
Thanks for reading!
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital & Elevate Ventures
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