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Are No-Fee Custodians Really Free?

Are No-Fee Custodians Really Free?

In the world of investing, it is important to have your money and securities held securely. The vast majority of these investments are held through a custodian. These custodians – Fidelity, Charles Schwab, TD Ameritrade, and others – are often custodian banks and are in the business of protecting clients’ assets and facilitating the tracking of the trades and transactions the client needs to execute in their accounts. Many Registered Investment Advisory (RIA) firms engage custodians on behalf of their client accounts and are tasked with understanding the costs associated with utilizing them. In recent years, many of these custodians have gone away from transaction costs for trading securities per trade and have adopted a “Zero-Commission” or “No-Fee” model. It is important to understand that this does not mean that there is no cost. 

Here are some of the main ways that custodians make money: 

Many custodians do not charge commissions or account level fees and brand this service as a “No-Fee” account. As my mother used to tell me though, nothing in life is free. 

Expense Ratios, Servicing Fees & More

With trillions of dollars on platforms like Charles Schwab, TD Ameritrade, and others, there is a lot of money to be made through the deposits that are often swept into the banks that own these custodians or operate directly with them. Even at small percentage points as low as 0.1%, they can generate billions of dollars in revenue. It remains to be seen if this is the best model for the RIA industry which, like us, works hard to bring value and fiduciary guidance to our clients.

Looking into the underlying fees that Exchange Traded Funds (ETFs) and mutual funds charge and how it fits into our client’s best interest is very important when evaluating the portfolios that are utilized. It is also important to know how those fees are being allocated to the custodians that we use. Since many of the custodians are no longer charging “commissions” for each transaction, there has been a rise in the number of assets that are being held by these custodians, creating an opportunity for them to make more money off of the deposits, cash, and servicing fees than they were able to make charging a commission. 

Managing the Bid-Ask Spread

Managing the bid-ask spread is another way that custodians can make money. The bid is simply the price that a buyer wants to pay for a security; the ask is the price that a seller wants to sell a security. The difference between the bid and ask is called the spread. In many cases, the spread of a security could be pennies. For example, at the time of this writing, the ETF SPY (one of the most frequently traded S&P 500 index funds) has a bid of $414.83 and an ask of $414.84. It doesn’t take a mathematician to realize that the spread in this case is a single penny. Custodians can profit by selling shares at the ask price and buying shares at the bid price (they are called “market makers” in this capacity). Some securities like SPY are traded over 100 million times per day. When that amount of trading occurs, pennies add up. We have discussed this in a past blog when many brokerages reduced their trading commissions to $0

Payments for Order Flow

Payment for order flow is yet another way that custodians generate revenue. Custodians can route trades through high-frequency electronic trading firms such as Citadel Securities. Somewhat behind the scenes to the average investor, Citadel is one of the largest market makers on the planet. By routing trades through firms like Citadel, custodians receive payment in return. Custodians may receive fractions of a penny ($0.001 – $0.002) per share. Again, this can add up when we are talking billions of trades.  

Custodians play an important role in the process for independent fiduciary financial advisors to manage their client’s investments and financial transactions. The partnership that we have together should continue to grow. Knowing where your money is held is vitally important, but it is also good to know how they are making money and collecting fees. Interest is a powerful measure of return on money, and banks are in the business of loaning out money to make money. They definitely have an “interest” in having more deposits and available cash.  

Jonathon Jordan