Cheap Money May Cost Discount Brokers

This column was originally published on RealMoney on Feb. 16 at 10 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Shares of discount brokerages TD Ameritrade(AMTD Quote), E*Trade Financial(ETFC Quote) and Charles Schwab(SCHW Quote) rebounded this week after getting hit on Tuesday by news that Wells Fargo(WFC Quote) will offer free trades.

The online brokers were boosted in part by news Wednesday from E*Trade that trading volumes and client assets grew at a healthy clip in January.

But the troubles for the online brokers are far from over, in my view, and free trades from competitors such as Wells Fargo and Bank of America(BAC Quote) are only part of the problem.

Here's the other part: These online brokerages get a disturbingly high portion of their revenue and income because they enjoy virtually free loans from their customers. If customers wise up and take away the cheap money -- which they can easily do -- the brokerages will suffer.

Cheap Money

Picking up on a practice started by Merrill Lynch(MER Quote) in 2000, the online brokerages offer laughably low default interest rates on idle cash in client brokerage accounts.

Ameritrade and E*Trade pay a paltry 0.1% for balances up to $5,000 and 0.4% for cash balances of more than $25,000. Because customers could earn as much as 4.8% in a money market account -- the kind of vehicle idle cash used to go into before Merrill Lynch changed things -- clients are giving up considerable sums. On a balance of $10,000 for a year, they forfeit about $440. Charles Schwab is a little better. It pays 1% as a default rate on idle cash for balances up to $100,000.

Yet all three brokerages offer much better rates to clients who ask:

• E*Trade customers can sweep brokerage account cash into a bank savings account that pays more than 5%. There are no minimums and no restrictions on how long the cash has to stay in the savings account, so the change wouldn't hurt active traders.
• Charles Schwab clients can sweep excess cash into money market funds that pay an annual yield of 4.7%. The initial minimum is $2,500, but after that it's $500. Clients can move cash out after one day without penalty.
• Ameritrade customers with $100,000 in assets can earn about 4.4% in a money market fund with an initial purchase of $5,000 and a minimum of $2,000.

If more customers wised up and took advantage of these better deals, what kind of damage would these brokerages suffer? Plenty. I dug into the financials recently to tally the sums, and it's not a pretty picture. Here's a look.