What are Discount Brokers?
What are Discount Brokers
Let’s go back in time a few years to the year 2000. You are in a great mood and want to purchase a state of the art, new, expensive television for your bedroom. Great! And so you quickly get ready, perhaps have a family member or friend come along, and go to the nearest big retail or electronics store to purchase the television.
And then a thought occurs to you: what if you purchased the television on the Internet, that fancy new thing that people were starting to use on their computers? The thought lasts a few seconds; you quickly forget about it and go to the store and purchase the television.
Now, put yourself in the present time. Imagine the same scenario playing out- could there not be, at some point in time, a strong resistance to go out to a Chroma, Vijay Sales, etc. and instead purchase the television on Flipkart, Amazon, or Snapdeal? You look up the television price online: it’s cheaper online! The reviews are fantastic, there’s an unbelievable return policy, the shipping time is very low, and you don’t need to go to a store at all.
And now the question becomes: why would you not purchase the television online?
Full Service Brokers
And with that analogy in mind, we introduce to you the concept of discount brokerage. We have all seen brokerage firms with their hundreds and thousands of branches sprawled Pan-India. You might have even walked into one of them at some point in time. A nice customer service representative would have spoken to you, told you about why you should choose that particular broker over the others, perhaps even showed you a demo of their trading software, and finally negotiate a brokerage deal with you. Ironically, the more often you trade, the lower the brokerage rates seem to be. For example, the relationship manager might state that if you do a combined traded turnover of 20 lakhs per month, your brokerage slab is 2 paise (which is equivalent to 0.02% of the traded value) brokerage. If you do more trades, the brokerage slab gets cheaper.
Once you open the account, the RM, as they are commonly referred to, will probably start calling you on weekdays to “checkup” on how you are doing. Within a few days, he/she will start recommending which stocks to buy and sell. The more active you get with your trades, the more active he/she gets.
And there is a direct conflict of interest here that often goes unnoticed by the customer, which we will get to later in the article. Many times, they end up closing the account. In fact, only 2% of the overall population trades or invests in the capital markets on one way or form, and that includes mutual funds. In the US, that figure is closer to 48% and is slowly climbing to above 50% levels. We often associate trading to gambling; we would rather purchase a Fixed Deposit that returns 8%, pay 30% taxes on the return, and have an investment that barely beats inflation versus investing in the markets that appreciate 15-20% annually and have 0% taxes on profits if you hold on to investments for more than one year.
And in enters the new breed of brokers: discount brokers. The term has a connotation that one is giving something up in order to earn a “discount” on price, but that is not true.
Discount brokers differ from full service brokers in many ways.
- They do not have branches or offices sprawled across the country. This drastically lowers costs.
- They do not offer advisory services and relationship managers. There are two major reasons for this.
- The first, as we alluded to earlier, is that there is a conflict of interest for a broker to provide tips on what to buy and sell. The broker earns revenue, and the relationship manager earns a commission. At the end, you’re left wondering if the RM truly has the customer’s best interests at heart. If the RM is getting paid a fixed salary + commissions on how much brokerage he/she can get his/her clients to pay, is it not in the RM’s best interest to give as many tips as possible via SMS and calls to their clients?
- The second point is more critical: not all customers want a relationship manager or advisory services. Some, if not the majority, just want a broker to execute their trades through. That’s it! So is it fair for a brokerage firm to employ hundreds of RM’s, a research team, and provide advisory services if all their customers do not opt for it? After all, that cost is being passed on equally to all customers.
- What’s interesting is that there are many independent, third party companies that do nothing but provide research reports, advisory services, and the likes to its customers. Therefore, one could execute their trades through a discount broker and opt for the 3rd party, who is not affiliated with the broker, for their research tools/advisory services. No conflict of interest = win-win situation.
- Many full service brokers claim that their trading platforms are superior to that offered by discount brokers. This is another major misconception. In fact, one could argue that since the overhead costs of discount brokers are so low, they can offer more resources towards ensuring a better trading experience for their clients. For discount brokers, the internet and online trading is their domain. Therefore, it would make sense for them to leverage the online world and technological offerings to ensure that the client’s ride is as smooth as possible. Call and Trades are usually picked up significantly faster via discount brokers due to the fact that the operation is centralized. Instead of having to call your RM, you call the broker directly and one of dozens/hundreds of customer service agents will immediately pick up your call and punch in your order.
- Finally, last but not least, there is a huge cost saving due to the fact that discount brokers do not charge brokerage. Instead, they usually charge a flat fee per order traded or sometimes, a flat fee per month for unlimited trading. For example, the broker might charge Rs. 20 per order traded regardless of the size of the trade. A typical Futures or Options trade is approximately 20 lakhs in trading value. Using 1 paisa brokerage, this comes out to 200 Rupees! With a discount broker, you end up paying something around 1/10th of the cost. That’s a huge saving.
The future is here
Discount broking is here to stay. It has become the de-facto norm in the West, where the concept of brokerage as a percentage of turnover traded does not exist. Relationship mangers that push certain stocks to their clients are a dying breed. Everybody now has a smartphone, so everyone is online. The account opening process for opening up an account with a broker has become more streamlined than ever before, with in person verification and KYC being done over webcams. Costs are going down, brokerage yields are going down, and retail trading/investing participation rates are quickly picking up.
Full service brokerages are trying to keep up, but are having a tough time competing with discount brokers. Discount brokers, on the other hand, are growing rapidly in pace. Some of the leading brokers make up 2-4% of the entire National Exchange’s traded volumes on a daily basis.
Discount broking is the future, and it is here today. The future is now, and full service brokers will just have to find a way to cope with the new competition.
After all, innovation is what leads to change for the better.