TCH: Disappearing Brokerage Commissions

           Few dates are as important in the history of the American stock market, at least for ordinary retail investors, as May 1, 1975. “May Day” brought about the abolition of fixed commissions, the high charges for trading in ordinary stocks and mutual funds defended by the keeper of the kingdom, the New York Stock Exchange. The regulatory change helped spawn a new cohort of discount brokers, some of them massive businesses today, that challenged the old full-service brokerage model that made investing simply uneconomical for ordinary people.

           However, the discount brokers themselves were only able to upend the old business model so much. It was not until the dawn of online trading, a technological solution to the scalability challenges of the brokerage business, that commissions began their descent into oblivion. Getting to the $0 commissions offered by brokerages left and right today took technological as well as regulatory change.

Full-Service, Full-Freight

           Charles Merrill, the founder of the brokerage firm Merrill Lynch, once remarked that “stocks aren’t bought, they’re sold.” The statement captures the essence of the brokerage business in those earlier days. However, the old full-service brokers like Merrill Lynch, the only kind of brokers in business before the mid-1970s, not only sold stock but also offered investment advice and sold research to their customers. They made up a brokerage industry much more personal in its operations than that of today.

           What made Merrill Lynch particularly successful, and somewhat unique, was a business oriented around retail investors. They advertised heavily in an industry not quite yet comfortable with reaching the masses and employed a large network of relatively trustworthy salaried brokers. They still pulled out all the stops though, offering a diverse array of financial products that went beyond stocks and mutual funds, all in a bid to “bring Wall Street to Main Street”, then a Merrill Lynch rallying cry.

           However, there was something problematic with the full-service brokers of yore: their cost. Brokerage commissions paid to transact in stock was until relatively recently charged as a percent of order size, as high as 2% for the smallest orders, on top of a fixed fee. This was tremendously expensive for small investors.

           In the United States, the protector of these lucrative commissions was none other than the New York Stock Exchange, which until May 1975, set the minimum commissions that could be charged by member firms. For example, from 1959 to 1968, the minimum commission it required on orders under $400 stood at $3 per 100 shares plus 2% of the amount traded (subject to a $6 minimum). In 1960s dollars, this was quite a high all-in cost.

           Under these rates, a hypothetical order for 100 shares of a stock trading at $2 would run up $7 in commissions or 3.5% of the order size. That said, even mildly larger orders did benefit from some economies of scale. It wasn’t any harder after all to fulfill an order for 100 shares of a $20 stock as it was an order for 100 shares of a $2 stock. The chart below tracks the minimum commission on an order for 100 shares of a $20 stock through the first three-fourths of the 20th century. Note that these numbers are not adjusted for inflation.

           Even large transactions incurred commissions gargantuan by today’s standards. For orders between $2,400 and $5,000, the NYSE’s minimum commission schedule through the 1960s called for a fee of $19 per 100 shares plus 0.5% of the amount traded. So, by way of example, someone buying 100 shares of textbook publisher and bond rating service McGraw Hill at year-end 1968, when they traded at $39.75 a share, would pay a little under $39 in commissions or about 1% of the transaction size. This amounts to around $280 adjusted for inflation and commissions were still higher for ‘odd-lots’, orders in increments other than 100 shares.

           What’s more, these were minimum commissions. Actual rates were often higher, even for ‘round lots’. For larger institutional investors, there was naturally a lot of bending of the minimum commission rules. Brokers competed by rebating these valued customers in ‘soft dollars’ that they could spend on research and other services, even entertainment expenses.

           Still a feature of the brokerage business today, these ‘soft dollars’ are a relic of this more regulated era in the brokerage business. Regardless, this gravy mostly benefited brokerage firms’ larger clients and not small investors. The result of the high price of trading was diminished popular enthusiasm for the stock market. Through the 1960s and early 1970s, the number of Americans owning stocks and mutual funds was falling steadily.

May Day

           The first step to reversing the trend was making the brokerage business more friendly to retail investors and reducing transaction costs was essential to achieving that. This meant dismantling the system of fixed commissions. Though it had hitherto approved the NYSE’s requirement that member firms charge a minimum commission, the Securities and Exchange Commission announced its intention to deregulate brokerage commissions in September 1973.

           The move, opposed by the NYSE and many brokers, was supported by some firms like Merrill Lynch that believed themselves able to compete better in a world of flexible pricing. After all, they had economies of scale and the SEC’s decision was essentially about extending competition to the retail business since deregulation had already begun on larger orders. The moment that changed the course of the brokerage industry came when the U.S. Congress amended the Securities Act of 1933, abolishing the practice of fixed commissions effective May 1, 1975.

           When “May Day” came, it was the beginning of a new world. Not so much because pricing immediately fell for small investors but because it nonetheless caused a shakeup in the brokerage industry. Deregulation enabled new business models and retired old ones. Some brokerage firms cut commissions quickly, some by 50%, but the price cuts were for large orders only. Small investors did not see commissions go down until the rise of the discount brokers brought a new approach to the brokerage industry.

Discounters

           The 1970s saw a flurry of new brokers enter the market with an emphasis on low commissions. These discount brokers, which included the likes of Charles Schwab and Quick & Reilly, offered a no-frills, low commission product, limited in its early years to trading domestic stocks and mutual funds. For some smaller full-service brokers, deregulation was the beginning of the end. Thirty NYSE member firms folded in 1975 alone; in time, many others left the business. The larger old brokers differentiated themselves by offering a wider array of supposedly high-quality services, like research and advice, and connecting investors with more diverse offerings of financial products, including municipal bonds and insurance policies.

           Though much has been said of the discount brokers, the no-frills business model was not enough by itself to reduce commissions to the negligible levels where they stand today. Retail investors still had to be mindful of their transaction costs as lower prices for the smallest trades came slowly. Early discount brokers charged minimum commissions not far lower than the old full-service brokers but better technology was about to change this.

Online Brokerage

           When online stock trading came around in the 1990s, it was exactly what was needed to make the brokerage business more efficient. The issue with retail brokerage was making what was traditionally a personalized business more scalable. The prior decade saw some important innovations aimed at resolving this impasse. These included the birth of telephone-based trading that allowed someone to use a phone keypad to place orders. Such a service was launched by Charles Schwab in 1989 and was dubbed TeleBroker. However, it was E*Trade that brought American brokerage into the internet-era, or to use that archaic and awkward expression, put it on the ‘information superhighway’.

           Launched in 1992, E*Trade gave early internet adopters in the days of America Online and Compuserve access to online stock trading. Some other discount brokers with offline origins, some with 1970s roots like Ameritrade, were quick to add an online platform. They also cut commissions, with ultra-discount brokers charging as little as $7 per trade by the year 2000.

           The internet meant that these online brokers could actually generate more revenue per account because simple online platforms encouraged more trading. There was also money to be made from offering ancillary services like margin lending to an increasingly sophisticated, or at least confident, retail investor base, aided in their education by more accessible investing literature. By the early-2000s, nearly the entire retail brokerage industry was converging online as traditional full-service brokers finished developing and launching their own online platforms. By the time mobile-app oriented brokers like Robinhood came around, commissions were well on their way to disappearing entirely.

Lesson

            In the retelling of the “May Day” story, much emphasis is placed on what it did to make investing more appealing for ordinary Americans. However, it is almost certain that even the most optimistic adventurers in the new discount brokerage business couldn't have imagined a $0 commission world. After all, in those early days, discount brokers were still plagued by slow manual operations in a business that ran on phone calls and paper. It took technological change to truly transform the retail brokerage business into what it is today and to render brokerage commissions a thing of the past.

Further Reading

1.      Blum, Gerald A., and Wilbur G. Lewellen. “Negotiated Brokerage Commissions and the Individual Investor.” The Journal of Financial and Quantitative Analysis, vol. 18, no. 3, 1983, pp. 331–343.

2.      Jones, Charles M. “A Century of Stock Market Liquidity and Trading Costs.” SSRN Electronic Journal, May 2002.

3.      Mihm, Stephen. “Voices: The Death of Brokerage Fees Was 50 Years in the Making.” On Wall Street, 3 Jan. 2020.

4.      Schwab, Charles. Invested: Changing Forever the Way Americans Invest. Random House, 2019.

5.      Zweig, Jason. “Lessons of May Day 1975 Ring True Today: The Intelligent Investor.” The Wall Street Journal, Dow Jones & Company, 1 May 2015.