The Business Of

Banking | Charles Schwab | How Do They Make Money?

Morning All!

So yesterday, we started the final part of The Business Of Banking. And our focus this week is on Charles Schwab, a company known for being a huge brokerage platform. But as we’ll see today, there’s a little more to it than that!

Now, usually we’d be seeing a pie chart of how Charles Schwab’s revenue is split. But we’re not going to do that just yet, because, it’ll be worth the surprise later on! I will remind you though that Charles Schwab made a whopping $21 billion in revenue in 2022. So without further ado, let’s find out how!

Wait, So They Do Make Money From Commissions… ?

Okay so, let’s pick up from where we left off yesterday. Charles Schwab and Hargreaves Lansdown both allow people to buy shares, funds, etc. on their platform. But we saw that whilst Hargreaves Lansdown charges their users £11.95 every time they make an equity trade, Charles Schwab don’t charge their users anything.

Now, before we look at how exactly Charles Schwab does make money from these trades. It’s important to know that it’s not just Charles Schwab that offers commission-free stock trading. The first company to ever offer commission-free trading was Robinhood back in 2013 – and over the last decade, their free trading offer has kind of forced Charles Schwab and other brokers to offer it too!

But back to our question - how do Charles Schwab and Robinhood actually make money from all the shares that investors buy through their app then? Well it’s something called payment for order flow (PFOF). For those of us who are familiar with the GameStop story, you’ll be well aware of what PFOF is. But for those of us who aren’t so familiar, let’s do a little breakdown now!

I’d also highly recommend this Netflix documentary on GameStop!

So, to start off, let’s look at the graphic below which we saw yesterday. Say I’m a Charles Schwab user and I click the BUY button on Tesla’s shares. Who actually does the buying for me? Well, it’s Charles Schwab! Charles Schwab will go to market makers (like Citadel, Goldman Sachs, etc) and buy the shares from whoever offers the lowest price. Charles Schwab will then send those Tesla shares to my account for the same price they received. And they’ll send the market maker (let’s say Citadel) the money I’ve invested.

Now, we know market makers benefit from this activity. We saw in The Business Of Goldman Sachs, that market makers will constantly be buying and selling shares and making a ‘spread’ on these trades. So in our example, Citadel would have benefitted from Charles Schwab directing my order to them. But the question is – do Charles Schwab give them that order for free? And the answer is no! Market makers have to pay Charles Schwab for that order! And this payment is called the payment for order flow.

Now, these payments are absolutely tiny. Like fractions of a penny for a trade. But given that 5.9 million trades a day occur on Charles Schwab’s platform, these pennies add up! In fact, payment for order flow brought in a sizeable $1.7 billion in revenue to Schwab in 2022!

Now, as some of you may know – payment for order flow is actually quite a controversial topic. And this practice is actually banned in the UK! But why is it so controversial and why is it banned in the UK? Well, this short video from the Wall Street Journal will help answer those questions!

Okay so that’s payment for order flow - revenue that Charles Schwab makes when assets are traded on their platform. But there is one other type of revenue Charles Schwab makes when assets are traded on their platform. And that’s commissions. But hold on – didn’t I say Charles Schwab offered no commission for investors?

Well, kind of! To clarify, Charles Schwab offer no commission on EQUITY TRADES. But they do charge investors commission if they want to buy other assets or derivatives, (e.g. bonds, mutual funds, options, futures, etc). Again, these commissions are very low percentages. But as millions of trades are done, they all add up!

As the chart below shows, commissions brought in $1.8 billion in revenue for Charles Schwab. Marginally more than what ‘payment for order flow’ made. So in total, this ‘trading’ revenue made $3.7 billion for the company in 2022…

… which means Charles Schwab made ~$17 billion of revenue in other ways! Let’s find out how!

0.13% Of A Big Number = A Big Number!

Alrighty, so the second revenue stream we’ll look at for Charles Schwab is asset management. And this follows on nicely from the trading part we were just talking about. When Charles Schwab started in 1971, they were just a brokerage that allowed investors to buy shares, funds, ETFs, etc. But then Mr Schwab thought, ‘hold on, we’ve created something that allows investors to buy stocks, mutual funds and ETFs. What if we offer them our own things!’

And so that’s what Charles Schwab did. From 1989, the company began their asset management division – Charles Schwab Asset Management - and started creating their own mutual funds and ETFs. And they charged an annual fee to investors who wanted to invest in those funds. Now, when we looked at The Business Of Ninety One, we saw that the UK asset manager charged an average annual management fee of 0.46% to investors. Which you may think is absolutely tiny. But as we can see below, the annual fees at Charles Schwab are even smaller! Schwab’s average management fee is just 0.13%!

And yes, 0.13% is tiny. But how many assets do Charles Schwab manage and hence charge that fee on? $1.6 trillion. What’s 0.13% x $1.6 trillion? A whopping $2.1 billion. Mamma Mia!

Okay so we’ve looked at management fees. But there’s a second revenue stream Charles Schwab makes from this asset management side of the business. And that’s to do with advice. What do I mean? Well, for people who don’t know which stocks or funds to invest in, Charles Schwab will advise them what to do - in return for a fee. As we can see from the screenshot below, these fees start at 0.8%. But in order to get this advisory experience, you need to have at least $500k with Schwab!

Now, as the screenshot above says – the fee rate comes down as you have more assets. So for the super wealthy, the fee rate will be well below the initial 0.8%. Overall, the average advice fee rate at Schwab was 0.42% in 2022. Which again, doesn’t seem like a massive figure. But in 2022, Charles Schwab advised on $542 billion worth of client assets. And what’s 0.42% of $452bn? A whopping $1.9bn. Below can see that this fee-based advice is close behind management fees in this ‘asset management’ segment.

Okay, so the asset management division makes ~$4.2 billion in revenue. And the trading segment makes ~$3.7 billion. That’s ~$8 billion. But where’s Charles Schwab’s other ~$10 billion of revenue coming from?! Well, we’re about to find out!

More Net Interest Income Than Barclays?!

Alrighty, so here it is. The third and final major way Charles Schwab make their money. And this is my favourite… because it’s absolute genius! It’s kind of like McDonald’s selling burgers and making money through rent. Well not quite the same, but you’ll see my point!

So, clients on Charles Schwab deposit money in their accounts. They buy shares, funds, etc. But here’s a question – do Charles Schwab users invest all the money their deposit in their accounts? Well, the answer is no. We saw yesterday that on average, ~5-10% of people’s money isn’t invested. It just sits in their accounts as cash. Why is this? Well, maybe they’re wondering what to invest in. Maybe they’ve received a dividend and haven’t invested it yet. To be honest, the reason isn’t that important. What’s important is that this money is idle cash. Which is often thought of as ‘wasted funds’ as you’re not making any return on it.

And this is where Charles Schwab saw an opportunity. They thought, ‘instead of this cash just sitting in our clients’ accounts and not making any money for them. Why don’t we take this cash, and give our clients a small interest rate. And then we’ll use the cash to invest in some assets and make a higher interest on it ourselves!’

And that’s exactly what they did… and still do! In 2003, Charles Schwab created a bank - Charles Schwab Bank - and started ‘sweeping’ all this idle cash onto their balance sheet.

Now, this is a little bit like what we saw last week in The Business Of Barclays. Barclays get a load of deposits from customers and then hand out those deposits as loans to make money. Charles Schwab on the other hand, also have deposits because of this idle cash they sweep into their own accounts. But instead of handing out loans like Barclays. CS just invests these deposits!

Now, where do they invest this idle cash? Well, the majority of these investments will be in safe, liquid, government bonds. And the important thing to consider is - what interest do Charles Schwab pay for their deposits? And what interest rate do Charles Schwab make on their investments? Well, our graphic below shows that whilst Schwab pays their account holders only 0.26% in annual interest for using their idle cash. Schwab makes a handsome 2.06% in interest from investing this idle cash!

But hold on a second - am I seeing things? In that graphic is says Charles Schwab made $12.2 billion in interest income (2.06% x $594bn). And had an interest expense of $1.5 billion (0.26% x $594bn). Which means Schwab make $10.7 billion in net interest income (NII). And yes that’s correct! Which is absolutely extraordinary when we saw last week that Barclays made £10.6bn in NII. So Charles Schwab made more NII than Barclays in 2022… incredible!

I don’t know about you, but I find that just ridiculous. Charles Schwab is known for its brokerage services. But the company make more than half of their revenue by simply taking the unused (idle) cash in their clients’ accounts. Investing it in super-safe government bonds. And making loads of interest! How wild and clever is that!

More Client Assets… More Revenues!

Alrighty, let’s wrap up! And finally we can look at our usual revenue split pie chart for Charles Schwab. As we’ve seen already, net interest income, asset management and trading make up pretty much all of the company’s revenues.

But one thing we haven’t really touched on today is growth. How has Schwab’s revenue grown over the years?

Well, unfortunately we don’t have time to really dive into this now. But the main driver for Schwab’s revenues over the years has been client assets. And this makes sense right? More people like me and you creating Charles Schwab accounts and depositing our money with Schwab means three things.

It means more trades (therefore more commission and payment for order flow revenue). It means more advice (and hence more fees). And it means more idle cash which Charles Schwab can use to invest (meaning more net interest income)! As we can see from the chart below, Schwab’s clients assets have grown a very healthy ~11% CAGR since 2006.

Now, a simple way to think about that 11% growth is splitting it into 2 parts; (i) the appreciation of existing client assets and (ii) new client assets. What do I mean? Well, let’s say I created an account with Charles Schwab in 2006 and invested $10k in a S&P500 mutual fund. Those assets will have grown from 2006 to 2022 because the S&P500 grew over that period!

So, that 11% growth in client assets isn’t because Charles Schwab are getting 11% more people signing up with them every year. A significant portion of that will just be from the stock market appreciating. Now, the S&P500 has grown at ~7% p.a since 2006. So we can assume that the remaining ~4% comes from new clients! And as we can see from the chart below, our 11% growth in client assets almost mirrors Schwab’s revenue growth of ~10% during the same period!

21st Nov 2023

Nigel Jacob CFA