Over the past three years, U.S. retail securities firms have been benefiting from rising interest rates, and some adjusted their strategies expecting rates would continue to rise. So when the Federal Reserve lowered the federal funds rate by 25 basis points on July 31, it not only abruptly reversed course from the preceding three years of nine rate increases, but it also delivered a blow to retail securities firms' bottom lines. The action, plus the lack of clarity on major economic and trade issues, leaves the timing and direction of future rate movements unclear. (For more, see "July 30-31 FOMC Meeting: Baby Steps Or A Shot In The Dark?," Aug. 1, 2019.)

S&P Global Ratings does not view the recent fed funds rate cut as a material ratings event for any firm given that the rate cut was modest and only reverses some of the benefit of previous rate hikes. Also, we believe it's unwise to try to draw conclusions on the longer-term impact on individual firms because changes in the fed funds rate are likely to affect other interest rates, brokers' clients, and securities markets in unpredictable ways.

However, the recent rate cut will reduce margins and profitability to varying degrees for rated retail firms, and it creates considerable uncertainty for these firms about the direction and pace of future rate changes. Particularly, it upends the strategies of firms that had positioned themselves to maximize the benefit of rising rates.

How Short-Term Rates Affect Brokers' Returns

The biggest impact of short-term rates is on the revenue brokers generate on clients' uninvested cash balances. The firms typically pay very little interest on clients' uninvested cash balances and earn revenue on them in one of three main ways: holding the cash at the broker-dealer, sweeping the cash to third-party banks or money market funds, or sweeping the cash to their own banks.

Cash held at the broker dealer (typically in segregated accounts):  Brokers can invest clients' cash to earn a spread, but regulation limits investments to very low-risk and low-yielding U.S. government issued or backed assets (Treasuries, Treasury repo, and insured bank deposits). So, spreads are low and very sensitive to the fed funds rate.

Sweep to third-party banks or money market funds:  Brokers are paid fees on cash balances swept to third-party banks, while customers gain the benefit of Federal Deposit Insurance Corp. insurance when swept to a bank. However, unlike when this is swept to a higher-yielding money market fund, the client typically doesn't earn a competitive rate on the swept cash. The specifics of these sweep programs vary, but typically, they include a rate-sensitive component that pays more when rates are higher, and these low-cost deposits are more valuable. Most of the larger self-clearing firms (LPL, TD Ameritrade, Oppenheimer, IBG, and Aretec in one of its units) operate sweep programs. The firms that don't self-clear (Advisor Group, Kestra, and Aretec in most of its units) use their clearing brokers' programs, whose role allows them to take a good amount of the revenue generated from the sweep program.

Sweep to owned banks:  The brokers that have banks (Schwab, Raymond James, Stifel, and E*TRADE) can earn a much wider spread sweeping to their own banks because the swept cash deposits can be invested in a wider variety of higher-yielding assets than a broker can. However, doing so involves taking on interest rate, funding, credit, and market risk.

Retail Brokers: Pausing To Evaluate Strategies After Years Of Rising Short-Term Rates

Rising short-term rates over the past three years were a boon to retail securities firms' profitability, albeit to varying degrees. This followed a long period of short-term rates close to zero after the global financial crisis. Very low short-term rates hurt retail brokers' profitability because they limit the returns brokers can earn on their clients' uninvested cash balances, which brokers typically pay very little interest on.

But rising rates, and the expectation that they would continue to rise, also caused many firms to alter their strategies. Many of the brokers without their own banks, particularly the independent firms that clear through third-party brokers, have sought to renegotiate their contracts with clearing firms' sweep programs to improve the economics for themselves. This is especially the case for some of the newer independent firms, as their acquisitions increased scale, giving them more clout with their clearing brokers. Ironically, some have recently revised their arrangements to include a more variable component in anticipation of rising rates.

At the same time, over the last three years, the brokers that own banks increased the amount of brokerage client cash balances swept to their banks so that rising rates would lift their net interest margins and returns. But in doing this, they increased their exposure to volatility in brokerage client cash balances and, in some cases, potential balance-sheet volatility in the name of profitability. For the discount brokers, this also helped to offset declines in commission revenue from price competition.

However, the change in the direction of rates has reduced the premium they can earn sweeping to their own banks relative to fees earned sweeping to other banks. This has already caused at least one firm to make a dramatic change in its positioning. At the end of the second quarter, E*TRADE sold $4.5 billion in low-yielding investments and shifted the sweep of $6.6 billion in client cash balances to third-party banks to reduce regulatory capital requirements to support future stock buybacks. In doing so, management prioritized earnings per share growth and capital return to shareholders over revenue growth and operating margin.

While the 25-basis-point reduction in short-term rates is unlikely to cause all the other retail securities firms to dramatically change their strategies, the uncertainty over the direction of rates likely will cause firms to reconsider their positioning. The brokers with banks could follow Stifel and Raymond James' model of having their banks invest more in higher-yielding loans, which are less affected by the fed funds rate. However, this also increases credit risk and cannot be done safely overnight.

Discount Brokers: Strategic Changes Have Had An Impact On Competition And Profitability

However, some of the changes in strategy have had more profound longer-term effects on competition and profitability among the discount brokerage firms (such as Schwab, TD Ameritrade, E*TRADE, IBG, and Fidelity). When rates started to rise in 2016, the additional revenue funded a trade commission price war among the discount brokers. While this did not materially change rated firms' market shares, it did reduce commission revenue per trade for all firms. At the time, the impact on their profitability was masked by the effect of rising interest rates. This was particularly the case for Schwab because its bank allows it to gain more benefit from rising rates. Plus, its commission revenue is a small proportion of overall revenue, which makes it the least exposed to a reduction in commission revenue.

However, charging lower commission rates and paying little interest on uninvested cash balances not only left such firms more exposed to falling short-term rates, but it also invited greater competition on the rates paid on clients' uninvested cash balances. IBG's Interactive Brokers has been advertising its higher rates on cash balances for years. Recently Fidelity highlighted that it pays a much higher rate than competitors as it automatically sweeps idle client cash to money market funds. While we believe that the rate paid on uninvested cash balances may not be clients' most important consideration, the additional attention it is drawing likely reduces firms' ability to decrease what they pay even if interest rates fall further.

That said, the high profit margins and other sources of revenue at the discount brokers provide plenty of cushion to absorb anticipated reductions in either net interest income or cash sweep revenue, even for E*TRADE and Schwab, where interest income accounts for about 60% of revenue. Conversely, while TDA would see a decline in sweep revenue from lower short-term rates, this would be limited because it's program is set up to limit exposure to changes in rates.

Other Retail Brokers' Exposure To Short-Term Rates

Rising short-term rates benefited independent and full-commission retail brokers but did not spark material competitive changes in these subsectors, like they did for discount brokers. Again, the full-commission retail firms with their own banks (Stifel and Raymond James) benefited the most from rising rates. However, because both these firms have large loan portfolios, they are less affected by changes in short-term rates.

Declining short-term rates could hurt profitability at Oppenheimer given its weak 5.7% pretax profit margin and the underperformance of its retail and capital markets businesses. That said, we believe the firm maintains positive momentum because of its progress resolving past regulatory and legal settlements, including reducing its auction-rate securities obligations.

The contribution of cash sweep revenue varies widely among the rated independent brokers, with self-clearing LPL's contributing the most, typically around 30% of net revenue. Among the other rated independent firms, cash sweep revenue accounted for as much as a quarter and as little as about a tenth of revenue. The contribution to earnings or cash flow is typically higher given that this revenue is not shared with financial advisers and has very little overhead associated with it.

Given the heavy debt load of the private equity-owned independent firms (Kestra, Aretec, and Advisor Group), a material reduction in this revenue, absent any offsetting increases elsewhere, could reduce debt service capacity. However, given the uncertainty over potential further rate cuts and the lack of financial covenants on their term debt, we believe we have adequately reflected this risk in our ratings on these firms. The firms would have to meet financial covenants if they drew material amounts on their revolvers, but we do not anticipate this.

Longer Term, It's About More Than Just The Direction Of The Fed Funds Rate

The 25-basis-point reduction in the fed funds rate does not affect our ratings on any firms given it was a modest cut and the lack of clarity on the direction and pace of future rate changes. We also believe it's unwise to try to draw conclusions on the impact on individual firms because changes in interest rates would not occur in a vacuum.

The lower fed funds rate could have other implications that ultimately benefit securities firms. It may lead to a reduction in LIBOR, or possibly longer-term rates, helping to reduce firms' funding costs. This would be particularly beneficial to the private equity-owned firms, which all have relatively large amounts of LIBOR-based floating-rate bank loans outstanding. More generally, lower fed funds rates could boost firms' client activity levels, or even the equity market itself, raising trading-related and asset-based revenue. And if firms start to believe short-term rates will fall much further or remain depressed for a longer period, they could try to adjust in varied ways--the results of which will play out over time.

Appendix: Securities Firms Rating Factors And Recent Rating Actions

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