AMTD/SCHW: DOJ May Examine Post-Merger Effects on Trade Execution Quality
Wed 04/22/2020 13:34 PM
Takeaways
The ability of brokerage firms such as Charles Schwab and TD Ameritrade to earn additional revenue from directing order flow could attract DOJ scrutiny, according to Reorg’s analysis and an industry veteran. This analysis is expected to occur within the agency’s broader review of potential anti-competitive effects of the deal on registered investment advisors, or RIAs.
In a practice widely known as payment for order flow, brokerage firms route orders in a way that generates rebates from exchanges and payment for order flow from market makers. This additional revenue stream is increasingly significant because most major brokerages have slashed trading commissions to zero.
Reorg’s analysis of trading volumes across major brokerages including Schwab, TD, E-Trade and Fidelity indicates that the two merging parties are well ahead of their peers when it comes to handling trading volumes on a daily basis.
An industry veteran, who has cooperated with the DOJ in its investigation of the merger, noted that the post-merger company would have a “substantial” trade volume relative to its peers. “That question of concentration is certainly going to be applicable on the retail side,” the industry veteran said.
Figure 1: Daily Average Trades - FY2019
As Reorg analyzed previously, fundamental drivers of the Schwab/TD deal pertain to cost synergies and Schwab’s ability to sweep uninvested cash to its banking subsidiary in order to generate higher net interest income.
Schwab’s first-quarter earnings in 2020, however, indicate that the Federal Reserve’s emergency rate cuts and lower interest rates are outweighing the benefits of higher levels of uninvested cash balances, also known as cash sweep balances.
According to Schwab, net interest revenue declined 6% year over year to $1.6 billion “due to pressure across the yield curve accelerating late in the quarter, which outweighed the impact of significantly higher levels of client cash sweep balances.”
While the Schwab/TD combination is expected to benefit from a larger cash balance post-merger as Schwab diverts uninvested cash from TD Bank to its own banking subsidiary, the pressure on net interest revenue in a low interest rate environment could compel the combined company to look at other revenue streams.
Schwab CFO Peter Crawford, on the investor call yesterday, April 21, conceded that Schwab will need to “continue to grow [its] revenue streams that are not spread related.” Non-spread-related revenue could include registered investment advisor, or RIA, custody fees and order flow revenue, among others.
Schwab has pledged not to raise RIA custody fees in the future. Whether the company sticks to its promise remains to be seen. Alternatively, the Schwab/TD combination may look to leverage their dominance in handling large trading volumes to enhance their order flow revenue in the future.
According to the industry veteran, Schwab’s promises to regulators and the public not to raise custody fees as well as the impact of the coronavirus pandemic could lead the firm to look at this option. “They’ve really put themselves in a corner where they’ll be looking for any route to maintain profitability,” the industry veteran said.
On the one hand, in 2019, Schwab generated $135 million in order flow revenue, which represented a miniscule 1.25% of the company’s total net revenue. On the other hand, TD Ameritrade historically has reported much higher order flow revenue. The company earned $492 million in order flow revenue in 2019, which represented 8% of the company’s total net revenue - a significantly higher share compared with Schwab.
In this context, for the combined entity to increase order flow revenue on the back of a daily average trading volume of 1.6 million trades (compared with Fidelity’s 625,000) is not entirely unrealistic. This could be especially true as other revenue streams such as net interest revenue face pressure due to a low interest rate environment. This potential scenario could nudge regulators to closely examine any possibility for the combination to sacrifice on trade execution quality and price improvement in order to maximize revenue.
Figure 2: Q4 2019 Net Price Improvement Per 100 Shares
As Figure 2 illustrates, in the fourth quarter of 2019, TD Ameritrade’s trade execution quality was lower compared with Schwab’s or Fidelity’s, with TD offering the least savings in terms of net price improvement per share while executing trades. Furthermore, TD tends to receive relatively higher order flow payments compared with Schwab across market makers. This explains the company’s relatively higher order flow revenue both in absolute terms and as a percentage of total net revenue. Fidelity, which offers the highest savings, maintains that it does not participate in selling order flows.
Figure 3: Payment Per Share For Order Flow - By Market Maker
For the DOJ, a potential question would be to examine whether a post-merger TD/Schwab combination, in an effort to diversify and monetize non-spread-related revenue streams (as articulated by Crawford) would seek to leverage its hold on high trading volumes to enhance overall order flow revenue. Although at the time of the deal announcement Schwab viewed order flows as a “dis-synergy,” the changed macro environment may compel the post-merger combination to explore this revenue stream more closely.
While discounting this possibility as a centerpiece in any challenge to the merger, the industry veteran agreed it was likely something the DOJ would examine in its investigation. However, defending the argument in court would likely prove difficult, the veteran noted. “If I’m a regulator, I want to go for maximum win with the least amount of resistance.”
Compared with the market of retail brokers that provide custodying services to investment advisors, the pool of brokers that direct order flow to market makers is much larger, the industry veteran noted. “If you look at historical precedents, the courts generally look at substitution as a quick resolution to the debate on whether there will be an antitrust issue,” the veteran said. Retail clients, therefore, could switch to other brokers that offer better trade execution, albeit with difficulty.
However, the potential for the combined company to leverage its post-merger trade volume is likely something the agency would examine as part of its overall investigation, the industry veteran said, noting that the DOJ will look at any impacts resulting from concentration.
The companies have said they continue to expect the transaction to close in the second half of 2020. Schwab declined to comment, while TD did not provide a response in time for this story’s publication.
Reorg’s previous coverage of this transaction can be found HERE.
--Shrey Verma and Matt Tracy
- The ability of brokerage firms such as Charles Schwab and TD Ameritrade to earn additional revenue from directing order flow could attract DOJ scrutiny, according to Reorg’s analysis and an industry veteran.
- The pressure on net interest revenue in a low interest rate environment may compel the combined Charles Schwab/TD Ameritrade to look at other revenue streams post-merger. Schwab CFO Peter Crawford, on the company’s investor call yesterday, April 21, said that the company “continue[s] to grow [its] revenue streams that are not spread related.”
- Data shows that the two merging parties are well ahead of their peers in handling trading volumes on a daily basis. For the DOJ, a potential question would be to examine whether a post-merger TD/Schwab combination, in an effort to diversify and monetize non-spread-related revenue streams, would seek to leverage its hold on high trading volumes to enhance order flow revenue.
- While discounting this possibility as a centerpiece in any antitrust challenge to the merger, the industry veteran, who has cooperated with the DOJ in its investigation of the merger, agreed this is likely something the DOJ would examine.
The ability of brokerage firms such as Charles Schwab and TD Ameritrade to earn additional revenue from directing order flow could attract DOJ scrutiny, according to Reorg’s analysis and an industry veteran. This analysis is expected to occur within the agency’s broader review of potential anti-competitive effects of the deal on registered investment advisors, or RIAs.
In a practice widely known as payment for order flow, brokerage firms route orders in a way that generates rebates from exchanges and payment for order flow from market makers. This additional revenue stream is increasingly significant because most major brokerages have slashed trading commissions to zero.
Reorg’s analysis of trading volumes across major brokerages including Schwab, TD, E-Trade and Fidelity indicates that the two merging parties are well ahead of their peers when it comes to handling trading volumes on a daily basis.
An industry veteran, who has cooperated with the DOJ in its investigation of the merger, noted that the post-merger company would have a “substantial” trade volume relative to its peers. “That question of concentration is certainly going to be applicable on the retail side,” the industry veteran said.
Figure 1: Daily Average Trades - FY2019
(Source: Reorg analysis of company 10-Ks and public disclosures)
As Reorg analyzed previously, fundamental drivers of the Schwab/TD deal pertain to cost synergies and Schwab’s ability to sweep uninvested cash to its banking subsidiary in order to generate higher net interest income.
Schwab’s first-quarter earnings in 2020, however, indicate that the Federal Reserve’s emergency rate cuts and lower interest rates are outweighing the benefits of higher levels of uninvested cash balances, also known as cash sweep balances.
According to Schwab, net interest revenue declined 6% year over year to $1.6 billion “due to pressure across the yield curve accelerating late in the quarter, which outweighed the impact of significantly higher levels of client cash sweep balances.”
While the Schwab/TD combination is expected to benefit from a larger cash balance post-merger as Schwab diverts uninvested cash from TD Bank to its own banking subsidiary, the pressure on net interest revenue in a low interest rate environment could compel the combined company to look at other revenue streams.
Schwab CFO Peter Crawford, on the investor call yesterday, April 21, conceded that Schwab will need to “continue to grow [its] revenue streams that are not spread related.” Non-spread-related revenue could include registered investment advisor, or RIA, custody fees and order flow revenue, among others.
Schwab has pledged not to raise RIA custody fees in the future. Whether the company sticks to its promise remains to be seen. Alternatively, the Schwab/TD combination may look to leverage their dominance in handling large trading volumes to enhance their order flow revenue in the future.
According to the industry veteran, Schwab’s promises to regulators and the public not to raise custody fees as well as the impact of the coronavirus pandemic could lead the firm to look at this option. “They’ve really put themselves in a corner where they’ll be looking for any route to maintain profitability,” the industry veteran said.
On the one hand, in 2019, Schwab generated $135 million in order flow revenue, which represented a miniscule 1.25% of the company’s total net revenue. On the other hand, TD Ameritrade historically has reported much higher order flow revenue. The company earned $492 million in order flow revenue in 2019, which represented 8% of the company’s total net revenue - a significantly higher share compared with Schwab.
In this context, for the combined entity to increase order flow revenue on the back of a daily average trading volume of 1.6 million trades (compared with Fidelity’s 625,000) is not entirely unrealistic. This could be especially true as other revenue streams such as net interest revenue face pressure due to a low interest rate environment. This potential scenario could nudge regulators to closely examine any possibility for the combination to sacrifice on trade execution quality and price improvement in order to maximize revenue.
Figure 2: Q4 2019 Net Price Improvement Per 100 Shares
(Source: Reorg’s analysis of Rule 606 reports and company disclosures
Note: Above calculations based on order size range of 1-1,999 shares)
As Figure 2 illustrates, in the fourth quarter of 2019, TD Ameritrade’s trade execution quality was lower compared with Schwab’s or Fidelity’s, with TD offering the least savings in terms of net price improvement per share while executing trades. Furthermore, TD tends to receive relatively higher order flow payments compared with Schwab across market makers. This explains the company’s relatively higher order flow revenue both in absolute terms and as a percentage of total net revenue. Fidelity, which offers the highest savings, maintains that it does not participate in selling order flows.
Figure 3: Payment Per Share For Order Flow - By Market Maker
(Source: Rule 606 reports and company disclosures)
For the DOJ, a potential question would be to examine whether a post-merger TD/Schwab combination, in an effort to diversify and monetize non-spread-related revenue streams (as articulated by Crawford) would seek to leverage its hold on high trading volumes to enhance overall order flow revenue. Although at the time of the deal announcement Schwab viewed order flows as a “dis-synergy,” the changed macro environment may compel the post-merger combination to explore this revenue stream more closely.
While discounting this possibility as a centerpiece in any challenge to the merger, the industry veteran agreed it was likely something the DOJ would examine in its investigation. However, defending the argument in court would likely prove difficult, the veteran noted. “If I’m a regulator, I want to go for maximum win with the least amount of resistance.”
Compared with the market of retail brokers that provide custodying services to investment advisors, the pool of brokers that direct order flow to market makers is much larger, the industry veteran noted. “If you look at historical precedents, the courts generally look at substitution as a quick resolution to the debate on whether there will be an antitrust issue,” the veteran said. Retail clients, therefore, could switch to other brokers that offer better trade execution, albeit with difficulty.
However, the potential for the combined company to leverage its post-merger trade volume is likely something the agency would examine as part of its overall investigation, the industry veteran said, noting that the DOJ will look at any impacts resulting from concentration.
The companies have said they continue to expect the transaction to close in the second half of 2020. Schwab declined to comment, while TD did not provide a response in time for this story’s publication.
Reorg’s previous coverage of this transaction can be found HERE.
--Shrey Verma and Matt Tracy
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