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E*Trade (NASDAQ:ETFC) is one of the leading brokerage firms in the U.S. To a layman it may appear that the company earns the majority of its revenue from trading commissions, however, that is not the case. In 2012, net operating interest income (nearly $1.09 billion) accounted for around 57% of the company’s total revenue while trading commissions accounted for only around 20%.
What Is Net Interest Income And How Is It Earned?
Like many other brokerages, E*Trade holds a significant amount of customer cash and deposits on its balance sheet, at any given point in time. For instance, the company had an average of around $32 billion in customer deposits and payables on its balance sheet during Q1 2013. These assets are a liability for the company because it must be returned on demand with interest.
The company tries to generate a return on these assets that is higher than the interest it pays to its customers. In doing so, it operates much like a bank that earns a higher interest rate on its investments and pays a lower rate to the deposit holders who fund its investments. The difference between the two interest rates is the company’s net interest spread and the income generated in such a way that its net operating interest income. The assets in which E*Trade invests include real estate loans, margin receivables, available-for-sale securities and held-to-maturity securities.
The company also uses some other sources of funds in addition to customer deposits to fund the purchase of interest-earnings assets. However, the proportion of such liabilities is much smaller when compared to the level of customer deposits.
What are the key drivers for this revenue?
Net interest income primarily depends on two factors: (1) the amount of interest earning assets that the company has, and (2) the interest margin (or spread) that it is able to generate on these assets. The net interest income tends to increase (decrease) with an increase (decrease) in both these factors. An increase in interest-earning assets provides the company a larger base on which it can earn a spread while an increase in interest spread improves the company’s return on the same level of assets. The reverse happens when either of the two factors decline.
What Are The Risks Involved?
As mentioned above, the majority of interest-earning assets at a brokerage are sourced from customer deposits. Since customer deposits need to be returned on demand, the company might have to liquidate some or all of its interest-earnings assets at a loss, in order to meet en-masse deposit withdrawal requests. Although the probability of that happening is low, the company has faced an en-masse withdrawals at least once in the past. In late 2007, well-publicized concerns about E*TRADE Bank’s holdings of asset-backed securities led customers to doubt the company’s continued viability. As a result, they withdrew approximately $5.6 billion of net cash and approximately $12.2 billion of net assets from the company’s bank and brokerage businesses. 
The company is also subject to interest rate risks as the market prices of the company’s interest-earning assets and interest-bearing liabilities may change at different times or by different amounts. If the prices of interest bearing assets decline more than the prices of liabilities used to fund such assets, the company could register losses.
We will soon publish a follow up article that discusses how the company’s net interest income has trended in the past and what can be expected in the future.Notes: