Trading volumes have been low for the past few years. Bloomberg’s MVOLUSE index, which monitors the combined daily U.S. equity traded volume, suggests that current volumes may be nearly half of what they were in the first quarter of 2009. Unfortunately, this spells trouble for brokerages like Charles Schwab (NYSE:SCHW), and E*Trade (NASDAQ:ETFC), which earn trading commissions each time a retail investor trades on their platform.
If volumes remain depressed going forward, we expect both firms to continue reporting unimpressive earnings. In that case, E*Trade, being a pure play brokerage firm, has more at stake — unlike Charles Schwab, where asset management fees (which are not dependent on volumes) account for nearly 40% of total revenue.
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Nevertheless, we believe that trading volumes will recover gradually as macroeconomic conditions improve. Also, if trading volumes improve, E*Trade is likely to see a greater improvement in trading levels than competitors like Charles Schwab. This is because its pricing structure attracts a higher number of frequent traders to its platform — who are likely to increase trading activity disproportionately once they gain more confidence in the strength of the recovery.
Looking inside E*Trade’s pricing structure:
While Charles Schwab charges its clients a flat trading commission of $8.95 per trade for equities, E*Trade follows a tiered pricing for its customers – charging $9.99 to customers who trade less than 150 times in a quarter and only $7.99 to customers who exceed this threshold.
Moreover, E*Trade’s margin lending rates are below Schwab’s and are increasingly more attractive for customers who borrow significant amounts. The difference in margin rates for Charles Schwab and E*Trade grows from 4bps for loans under $25K to 2.36% for loans in excess of $1 million. That means customers pay 2.36% less in interest payments (for margin loans of over $1 million) at E*Trade than at Charles Schwab. (Look at a comparison of the two brokerages here.)
Given the above statistics, it seems logical that active traders and bargain hunters tend to stick with E*Trade, while Charles Schwab, with its focus on customer service and product range, remains a favorite for long term investors. The fact that E*Trade levies an account maintenance charge on customers whose trading activity or account balance is very low should also ensure that most of their clients are frequent traders. 
Our estimates support this rationale. According to our calculations, E*Trade customers traded almost 12 times on an average in 2012 while Schwab’s customers traded only around seven times on average last year. The difference was even greater in 2008 when Etrade customers traded almost 19 time year on average and Schwab customers lagged behind with only 10 trades a year.
How could this impact the share price?
As visible in the two charts above, the decline in trading activity for active traders (E*Trade customers) after the recession was much greater than that of Schwab customers. Assuming that trading volumes will gain steam over our forecast period, it is logical to believe that both active traders as well as long term investors will resume trading at levels that are consistent with their pre-crisis averages.
That means the increase in average annual trades per account for E*Trade is likely to be greater than that of Charles Schwab. We have updated our model to reflect this rationale and our new price estimate for the firm is about $9.Notes: