At Yahoo: Taking Stock of Commissions

I write at Yahoo! about Taking Stock of Commissions:

On May 1, 1975, fixed commissions were abolished on Wall Street. From an era of charging fixed commissions on a per-share or percentage basis, the model moved to "negotiated" commissions - charge anything they wanted. The day was called "Mayday" - an indication of the distress the industry felt about losing the profitability of cartelized price control. On October 27, 1986, the same thing happened in the UK, and the day was called the "Big Bang Day". Losing fixed commissions seems equivalent, in the industry, to Armageddon; but in both the cases above, after a brief hiatus, the UK and US have only benefited with the reform. They are now the largest markets in the world.

India has only started down this route - let's see where the primary investment avenues lie with respect to commissions.

Buying Shares

In India, stock broker commissions are not fixed, but they are strangely convoluted. When you buy a stock, you usually get charged a percentage of the trade value - that is, quantity multiplied by the share price, usually between 0.1% and 0.5%. And that's just brokerage. My contract note - a sheet that has everything that's charged to me for each trade - has all these additional charges:

• Service tax and Cess: a 10.3% tax on the brokerage, paid to the government.
• Securities Transaction Tax (STT) : 0.25% of the trade value, only applicable when I sell, goes to the government.
• Stamp Duty, Turnover Charges: Regulatory fees payable to the state, exchange or SEBI, usually a percentage of trade value - about 0.004%. This is so small they might only quote it as "400 rupees per crore".

In addition, some brokers charge a demat fee of about Rs. 15 per transaction and annual demat or account charges. To complicate matters further, brokerage, STT and exchange fees are different for intraday trading (buying and selling within the day), futures and options. Specifically in options, the brokerage is ridiculously high - upto 2.5% of premium paid or received with a minimum "per-lot" charge, usually Rs. 50 or so.

Trading then might cost more the advertised brokerage shows, and usually shocks first-time investors. But one question has to be asked - just why are commissions a percentage of trade value?

A long time ago, trading was done in the open-outcry format, where you found a crowd of (mostly) men in the well of a stock exchange, making strange hand signals and recording trades. That, anyone will agree, involves more work for more shares and proportionate fees are acceptable. All stock trading is electronic now, and the hard work of making strange signals is now the responsibility of silicon, not a carbon based life form. Then why should selling 1000 shares cost more than selling 10, especially when it comes to brokerage paid (one might understand STT or exchange fees)? Why is the "pay-per-trade" model, so prevalent in the US today, not popular among brokers to get market-share?

Some of the current efforts are half-baked - like a Rs. 5,000 for trades upto Rs. 7.5 crore, which is just another percentage brokerage concept, or a Rs. 1000 per month but the trading tools are unreliable. Others are in their infancy. (Disclosure: I'm advising a company offering fixed pay-per-trade rates.)

In order to move in this direction, technology needs to catch up at the broker and retail ends. You have absolutely fantastic trading terminals at brokerages in the US, but very little innovation seems to have happened in the area in India. The big players in this space in India are partly owned by companies who are owners of the stock exchanges themselves (NSE and MCX, for instance) and brokers have invested precious little in technology that lets investors gather data and make their own decisions. Lower commissions from competition might actually prompt innovation.

Mutual funds

SEBI cut out entry loads in 2009, from a fixed 2.25% to zero. The entry load went to compensate the "advisor", whose role had degenerated into very little actual advice and more filling forms properly. Again, a percentage hardly makes sense here - the service can't cost more for larger amounts; and SEBI's decision has forced distributors to charge customers directly. This is a dramatic shift from a business model that had become lazy - all you needed to do was tell a customer "Buy This Fund" - you would make your 2.25%, and the customer was none-the-wiser. Or, to get business, advisors would "rebate" commissions back to the investor, even though the practice could get them banned. This was silly - if both investors and advisors can negotiate a lower payment, why not let them?

Now, with no "loads", it is hardly likely that someone will pay Rs. 2,250 to an advisor just to fill a form for a 1 lakh investment - so either commissions will go down, or advisors will have to demonstrate that they can actually provide valuable advice. Filling forms with the same data, over and over again, is redundant -what works better is an electronic platform or exchange, which we are already moving towards, with the BSE and NSE opening up "MFSS" segments for transacting in mutual funds. (You'll still pay brokerage, though)

But until this happens, mutual funds will dip into their management fees, providing advisors with commissions anyway; but like we have learnt to pay stock brokers separate commissions, we'll learn to pay financial advisors separately.

Insurance

The insurance industry still builds-in commissions, with some charging as much as the entire first year's premium, on the flimsy excuse that this is a long-term product. (If it was a long-term product, why don't they spread the commissions over the term instead?) After the SEBI-IRDA turf war, rules are now in place to make investors more aware of the costs in ULIPs, but traditional endowment insurance remains an opaque product with loaded commissions.

Fixed Deposits

For fixed deposits at post-offices to banks, a small commission (0.5% to 1%) is paid to the intermediary, if you buy it from a bank The post office or bank will pay the intermediary, but will offer you the full interest rate on your deposit. The economy of scale works as well - for larger amounts, commissions are reduced and customers are offered higher rates.

Incentives shape behavior, and big distributors like banks will push customers towards products that give bigger commissions. For a while they pushed ULIPs, and now they focus on portfolio management schemes, traditional endowment insurance and structured products; but it's just a matter of time before investors get literate enough to feel betrayed. It's not like the banks shouldn't get paid, it's just that they seem to get a larger chunk than they deserve.

In financial investments, the percentage commission structures are strange, as the cost is very rarely dependant on the size of the transaction. Regulators are keen to push the intermediation cost directly to the consumer - ensuring that investors or institutions that do their own homework will get the best deal. Advise should be paid for separately anyway - because if you link it to a percentage of the transaction, what happens when the best advice is to do nothing? (This, in my experience, is true most of the time. Investing is a boring business.)

Financial players have the road-roller of change coming in their direction, in the form of lower commissions. They can stand where they are and protest, or prepare for the eventual smoother ride.

Related posts:

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This entry was posted on Thursday, December 30th, 2010 at 8:04 AM and is filed under Yahoo. You can subscribe to any comments to this entry via RSS 2.0. You can leave a response, or trackback from your own site.